Will it be the axe for prepayment penalty?

By BankBazaar.com | November 20, 2009

Recently the Reserve Bank of India (RBI) has hinted at drafting a policy to restrict banks from imposing prepayment penalty of retail loans. The proposed move follows many such complaints from loan borrowers paying EMIs based on the floating rate of interest. They feel that they are missing out on the benefits of periodical rate cuts in interest.

Ramesh has been paying EMIs on his home loans for almost 5 years now and now he wants to prepay his home loan! But he is worried about the prepayment penalty that his bank would impose on him! But why would the banks or the lenders mind when you pay back early? Do you stand to lose out on this deal or do you gain? Why and when people should opt for prepayment?

What is prepayment? Why and when do people opt for it?

It’s just what the name implies: prepaying all or part of the loan amount before it is actually due. However, it is more complicated that it sounds! First, you will have to check your retail loan documents to find out if prepayment is allowed and the percentage of outstanding loan amount that you will paying towards prepayment penalty charges, if any.

You might want to prepay your home loan for two simple reasons. First, you could save on the net interest payable as longer loan tenure means more interest paid. The second reason is that you can own the asset earlier than planned.

You could decide to prepay your loan if you have the capacity to make larger payments or if you have had a promotion or received a bonus.

Why do banks charge penalty for prepayment?

Well, banks and lenders lend money in the form of loans only to make money out of service fees and interests. And this requires the loan to be open for a fairly longer duration to give profits. They cannot stop your legal right from making a prepayment. But at the same time prepayment would mean upsetting their profit calculations from interests. Hence, the banks and lenders impose a prepayment penalty to compensate a portion of the lost profit. Usually your loan agreement would have a clause defining your obligations and interest in case of prepayment in part or in full.

RBI’s current stand on this penalty

Recently the Reserve Bank of India (RBI) has hinted at drafting a policy to restrict banks from imposing prepayment penalty of retail loans. The proposed move follows many such complaints from loan borrowers paying EMIs based on the floating rate of interest. They feel that they are missing out on the benefits of periodical rate cuts in interest.

Recently, the anti-monopoly body Competition Commission of India (CCI) is dealing with complaints from loan borrowers against collecting prepayment penalties on home loans from major lenders in the country.

Prepayment penalties by different banks in India

Public sector banks charge 1 to 1.5 percent as prepayment penalty on outstanding loan amount and in the case of private banks it is between 2 and 4 percent.

Name of the bank Prepayment penalty (in %)
Axis Bank No prepayment penalties
ICICI Bank No penalty on part-prepayment2% on foreclosure (+ applicable service tax)

This will be calculated on the outstanding loan amount and amounts prepaid in the last one year, if any.

LIC Housing Finance 2% on the principal amount prepaid
HDFC 0 to 2% on loansIf a prepayment is made within 3 years of the first disbursement subject to terms and conditions, 2% on the prepayment amount if the amount being repaid is more than 25% of the opening balance.
SBI Home loans No prepayment penalty if the loan is prepaid from own savings/windfall gains for which documentary evidence is produced by the customer.

How prepayment can benefit you?

Perhaps the biggest benefit of prepaying loans is saving on the net interest payable. Usually you could find out how much you save on the interest based on the amortization chart provided by your bank. Moreover you could own the asset bought on loan earlier than planned. Some banks also allow for part-prepayments say every quarter. This could effectively bring down the principle amount and the outstanding loan amount and subsequently the net interest. Here’s an example.

Ramesh took a home loan of Rs. 20 lakh for 20 years as loan tenure and at an interest rate of 12 percent. At the end of 20 years the net interest would be Rs. 32.85 lakh. Instead Ramesh decided to pay two additional EMIs every year, which would mean he could close the loan in 13 years time. His bank loan agreement had mentioned that there would be no prepayment penalty unless he paid off more than 25 percent of the principal in a year. The table below shows two scenarios and how opting to pay extra EMIs in a year actually helped Ramesh save on interest.

    Details Scenario 1 – 12 EMIs/year Scenario 2 – Two additional EMIs every year
    Interest rate per year 12% 12%
    Tenure of loan 20 years Since two additional EMIs are paid every year the loan tenure is reduced to 13 years
    Amount of loan taken Rs. 20 lakh Rs. 20 lakh
    Net interest paid Rs. 32.85 lakh Rs. 19.58 lakh

Prepayment can be made in part or in full. If you have plans to make a full repayment read carefully about prepayment penalty charges on your loan agreement. Some banks might allow you to prepay up to a certain period without any prepayment penalty and in this case you could if possible garner enough funds to foreclose before the expiry date it is fine.

If your loan agreement allows you to make part prepayment, then you could do so say every quarter. This way you could save some money, reduce the principal and the outstanding loan amount and the net interest rate.

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