Prepayment penalty – a sum amounting to as much as 2% of the unpaid loan – is charged by banks in India if a borrower intends to pre-pay the remaining EMIs in one go and close the loan. Akosha team dug into the issue and here is what we found.

Introduction

In 2006 when Ashish Raizada (also an Akosha customer)sought to buy a home for this family he undertook a home loan from HDFC Home Finance. At that time he could not have predicted the circumstances that were to engulf him four years later. In those four years due to a financial stringency, that wasn’t totally isolated from the global recession, Ashish encountered a setback. These factors contributed to Ashish’s realization that there was no way he would be able to continue his EMIs considering the steep interest rate; hence Ashish decided that he would pre-close his loan in 2011 by paying off the entire balance amount from his own sources in one go (by selling the home), thus, releasing himself from the interest stranglehold. However, he was in for a rude shock when his prompt and complete repayment cost him Rs. 50,000. When he asked HDFC about this they conveniently explained that this was a prepayment penalty.

What is prepayment penalty?

The term prepayment penalty refers to a cost borrowers have to incur if they choose to settle their loan before the pre-decided duration. The idea of this penalty may seem ironic to some; “Shouldn’t the bank encourage prompt repayment?”, “Isn’t it better for a bank if the borrower pays the whole loan amount at one go (that too early) instead of a measly EMI payment?”. Common logic dictates that these doubts are justified but a little economics is all that is needed to erase them.

In order to understand this we must understand the reason why banks choose to give a loan. Economically speaking, what is the bank’s incentive? The simple answer to this question is: interest. The interest they will earn over a period of time combined with the repayment capability of the borrower are the factors based on which banks decide whether to grant a loan or not. Out of these two factors interest can be termed as the primary factor, since this is what the banks stand to earn from their “investment” in their borrowers. So consequently the banks do encourage prompt repayment but the later you pay, the more the banks stand to earn. Moreover, if you choose to pay a large amount which you were actually supposed to pay back in little instalments combined with interest over 15 years at once then the banks lose out on the major chunk of their revenue. This fear inspires the banks to employ policies such as prepayment penalties.

Two kinds of prepayment penalties

In the present scenario these prepayment penalties are employed by the banks in two situations; first where you choose to pre-close your loan by repaying the entire balance amount at once before the set duration of the loan, secondly where you discover that a loan from another institution will cost you less (due to lower interest) and choose to transfer your loan there. In both of these cases the penalty charged is almost 2% of the balance loan amount remaining. However, the implementation of this penalty is not free from controversy in any of its forms. There has been immense debate on the legal validity of the use of these policies by banks.

As regards the first situation, where a borrower chooses to pre-close the loan by repaying the entire balance amount at once, a distinction has been drawn depending on whether you choose to pay the amount from your own funds or whether you procure the funds from somewhere else (which leads us to the other situation). The National Housing Bank, which regulates the functioning of all registered housing finance companies, issued a strict directive on October 18^th, 2010 precluding all the registered housing finance companies from charging a prepayment penalty where a borrower repays the entire balance amount before the pre-decided duration out of his own sources. (see the list of registered housing finance companies below and a copy of the directive). This directive, which came into immediate effect, also mentioned that any non-compliance would be dealt with seriously under the National Housing Bank Act, 1987.

PLEASE NOTE: This directive may NOT apply to loans other than housing loans.

Therefore, if your bank or housing finance company is registered under the list given below, and they are still asking you to pay prepayment penalty, you can bring the October 18^th, 2010 directive to their notice and complain to the National Housing Bank if necessary. See also the Akosha Guide to Approaching the Banking Ombudsman.

The policy of imposing a prepayment where a borrower transfers his loan to another bank offering a lower interest rate is a bit more complex. Ideally, if a borrower has undertaken a loan with say 10% interest, he should be entitled to transfer this loan to another bank if it offers him the same amount at 8%. Though this transfer-prepayment penalty has received considerable flak for offering very little flexibility to the borrowers, no concrete measures have been taken to check this practice. The Competition Commission of India in its very first final decision recognized this on-going practice as a legally valid trade practice (here is the link for the Competition Commission of India ruling – http://www.cci.gov.in/menu/RPrasadDissenting.pdf )

Conclusion

However, despite some bold measures taken by the regulating bodies in aiming to help the common consumer, there is a lot that is left to be desired. Most importantly, there is need for a strict implementation of any and all of such regulations, moreover, any non-compliance must be dealt with seriously in order to aid and further the cause of consumer protection.

List of housing finance companies registered under the National Housing Bank Act

(*As checked on 14 July 2011)

National Housing Bank Notice

Text of the notice:

The issue of levying prepayment penalty or prepayment charges by housing finance companies on pre closure of housing loans by the borrowers out of their own sources has been considered by the National Housing Bank and it has been decided that housing finance companies should NOT charge prepayment levy or penalty in such cases.

It is, therefore, advised that prepayment levy or penalty should not be collected from the borrowers when the housing loan is preclosed by the borrowers out of their own sources. All HFCs are advised to ensure compliance of the above with immediate effect.

Please note that non-compliance with the above advisory may attract penal consequences under the National Housing Bank Act, 1987.

Please acknowledge receipt.

Yours faithfully,

R S Garg

General Manager

Department of Regulation and Supervision

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