Where your EMI really goes: How much is principal vs interest

If you have an active loan, you must be aware that your loan EMI comprises two components: principal and interest. Since banks typically use the monthly reducing balance method, the portion of interest changes each month. This means in the first few months, the amount of interest that constitutes EMI is high vis-à-vis later months of the loan tenor.

In other words, the first EMI of your loan would have the lowest portion of principal (and the highest interest)—the split between principal and interest changes with every month. And as the loan tenor comes to an end, the principal becomes the highest, while interest is the lowest.

Monthly reducing balance

Let us understand the concept of the reducing balance method with an example.

Suppose you have a ₹3 lakh loan to repay (with 10% interest) in the next 12 months. The repayment plan computes the monthly loan instalment at ₹26,375. When you split this loan instalment between principal and interest, the first instalment would show interest-principal split as this: interest (2,500) and principal (23,875). You can compute your loan's EMI with the help of EMI calculator here.

The following month, interest would fall to ₹2,301 while principal would increase to ₹24,074. In the third month, interest would further decrease to ₹2,100, whereas principal would increase to ₹24,274.

This continues till the last instalment, when your principal-interest would look like this: ₹26,157 - ₹218.

The rationale is simple: interest is calculated on the outstanding principal. As you continue to repay your loan through instalments, the amount of outstanding principal falls and so does your interest.

Therefore, if you have surplus money you want to use to prepay one of the many loans running, it is recommended to prepay the loan with several years of repayment left, rather than the one that is about to end anyway.

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