The simplest way to assess the affordability of the loan is to look at the EMI. Lower the EMI, the more affordable the loan is. Because that’s the hard cash you must pay every month. The EMI depends on the loan amount, the loan tenure, and the interest rate. And you can tweak around these numbers to increase your affordability. For instance, the EMI size goes down with increase in loan tenure. Everything else being the same, you would go with a lower EMI. Makes sense too.
However, a lower EMI may not always mean a lower rate of interest. Even with the same loan amount and the loan tenure. How is that possible?
Let’s consider 2 loans.
Loan: Rs 10 lacs, Interest Rate: 10%, Loan Tenure: 5 years
- Loan1 EMI: Rs 21,247 per month
- Loan2 EMI: Rs 21,071 per month
Everything is the same but the EMI is different. How?
EMI in Arrears vs EMI in Advance
Loan1 is EMI in Arrears.
Loan2 is EMI is Advance.
What is the difference?
EMI in Arrears is the standard EMI product, the one you usually encounter. You pay your first EMI after a month (or on a specified date).
EMI in Advance requires you to pay the first EMI at the time of disbursal. In fact, it is adjusted with the disbursed amount. That, in a way, reduces the actual loan amount. Since the first EMI is paid at the time of disbursal, the first EMI is only principal repayment (and no interest payment). This scheme is usually used with car loans.
The cost of the loan remains the same under both EMI modes. Yes, that’s right. In the above example, it is 10% p.a.
Even though the cash flows are slightly different in the two cases, the cost of the loan will still be the same. However, there can be minor differences if there are ancillary charges such as processing fee.
How to Calculate These Two EMIs?
You can use Excel function (PMT) to find the EMI.
PMT (Monthly Interest Rate, No. of installments, Loan Amount, 0, Arrears/Advance)
For EMI in Arrears, use 0 in the final argument. For EMI in Advance, use 1. It is that simple.
Loan Amount = 10 lacs, Interest Rate = 10% p.a., Loan tenure = 5 years =60 months
- EMI in Arrears = PMT (10% ÷ 12, 60, 10 lacs, 0, 0) = Rs 21,247 per month
- EMI in Advance = PMT (10% ÷ 12, 60, 10 lacs, 0, 1) = Rs 21,071 per month
If you are not comfortable with spreadsheet software, you can try our calculator.
EMI in advance is lower. So, is it better or cheaper than EMI in Arrears? No, it is not. EMI in Advance is lower simply because the net loan amount is lower. In this example, the net loan is Rs 10 lacs – Rs 21,071 = Rs 9.79 lacs.
Here is some interesting math. If you reduce the loan amount (Rs 10 lacs) by EMI in Advance (21,071) and then calculate the EMI in Arrears using PMT formula, you will get the same number (Rs 21,071)
Loan = Rs 10 lacs – Rs 21, 071 = Rs. 9.79 lacs
Now, calculate EMI in arrears for 1 less month of tenure.
PMT (10% ÷ 12, 59, 9.79 lacs, 0, 0) = Rs 21,071 (this was the EMI in advance).
Hence, the difference is simply because of the net loan amount. EMI in Advance is same as EMI in Arrears loan of Rs 9.79 lacs for a tenure of 59 months at 10% p.a.
Impact of Processing Fee and Other Ancillary Charges
With EMI in Advance, the net loan amount is lower. Therefore, any fixed cost such as processing fee will be spread over a smaller amount. Thus, any such cost will increase the cost more for EMI in Advance. But the impact will be minor unless such fixed charge (as % of loan amount) is high.
Let us understand this with the help of an illustration.
Loan Amount = 10 lacs, Interest Rate = 10% p.a., Loan tenure = 5 years (60 months)
Processing Fee: Rs 5,000
- Net cost EMI in Advance: 10.22% p.a.
- Net cost EMI in Arrears: 10.21% p.a.
Processing Fee: Rs 10,000
- Net cost EMI in Advance: 10.45%
- Net cost EMI in Arrears: 10.43%
Processing Fee: Rs 20,000
- Net cost EMI in Advance: 10.91% p.a.
- Net cost EMI in Arrears: 10.88% p.a.
As you can see, the impact is not very significant.
The impact will also depend on the loan tenure. Shorter the tenure, greater the impact.
For the same processing fee of 20,000 and loan tenure of 3 years (instead of 5 years).
- Net cost EMI in Advance: 11.48% p.a.
- Net cost EMI in Arrears: 11.39% p.a.
The impact of processing fee on the overall cost of loan is higher on short-term loans.
| Purchase cost | 1,500,000 | |
| Own funding | 500,000 | |
| Loan | 1,000,000 | |
| Loan Interest Rate | 10% | |
| Loan Tenure of 5 years | EMI in Arrears | EMI in Advance |
| Amount | 21,247 | 21071 |
| Difference in EMI | 176 | |
| Net Cost of Loan (No processing fee) | 10% | 10% |
| Net Cost of Loan (Processing fee: 5,000) | 10.21% | 10.22% |
| Net Cost of Loan (Processing fee: 10,000) | 10.43% | 10.45% |
| Net Cost of Loan (Processing fee: 20,000) | 10.88% | 10.91% |
| Loan Tenure of 3 years | EMI in Arrears | EMI in Advance |
| Amount | 32,267 | 32,001 |
| Difference in EMI | 267 | |
| Net Cost of Loan (No processing fee) | 10.0% | 10.0% |
| Net Cost of Loan (Processing fee: 5,000) | 10.34% | 10.37% |
| Net Cost of Loan (Processing fee: 10,000) | 10.69% | 10.73% |
| Net Cost of Loan (Processing fee: 20,000) | 11.39% | 11.48% |
How Should You Consider This Information?
We have seen that the difference is not much, and this seems more like an academic exercise. However, you must still be aware.
What if the bank quoted you an EMI of 21,247 (same as EMI in Arrears) but it happened to be an EMI in advance loan?
Your net cost would be more than 10% p.a.
10.37% p.a.
Hence, the lenders can show you a lower EMI by playing these minor tricks. As a borrower, you must understand the loan structure and calculate the all-in cost (processing fee, interest rate, other charges).
Loan Is a Contract. You Can Word It in Any Manner
Now, it is not written anywhere that only 1 EMI must be paid in advance. For instance, in the same example, the lender can collect 3 EMIs in advance and the borrower must repay the loan in the next 57 monthly installments.
In such a case, the EMI would only be Rs 20,735. Same interest rate of 10% p.a.
However, if the lender were to offer you an EMI of Rs 21,247 (as was in EMI under Arrears) but charged 3 installments upfront, your net cost of loan would be 11.1% p.a. (and not 10% p.a.)
Thus, a bit of spreadsheet knowledge is always useful.