"Rationale of Prepayment Penalties charged by Indian Banks
on Loans"


By

Dr. Vikas Trivedi
Lecturer
CZ Patel College of Business and Management
Vallabh Vidyanagar (Anand)
 


Introduction:

Like any commercial entity, money lending institutions think about profit margins to thrive and survive. Loans and advances by banks form one of the most important and fundamental functions of a banker. A major chunk of banks revenue comes from its lending activity. Of the many charges levied by banks on loans, an important and hitherto untouched charge is Prepayment Penalty. This article is intended to throw light on this unremarked issue of Indian Banking System. 

Pre-Payment Charges: The Concept

A charge levied by a lender on the borrower who repays all or part of the principal of a loan before it actually becomes due. The prepayment penalty compensates the lender for the loss of interest that it would have earned, had the loan remained in effect for its complete term.

Table 1 depicts the rate of prepayment charges charged by major players in the banking sector, namely state Bank of India, ICICI Bank and HDFC Bank in major retail loan segments, namely Personal Loan, Car Loan and Home Loan.

Table 1: Pre-Payment Penalties charged by Banks in India

Bank

Personal Loan

Car Loan

Home Loan

ICICI Bank

5% of Principal outstanding, or interest outstanding for unexpired period of loan.
(Whichever is lower) 

5% of Principal outstanding, or interest outstanding for unexpired period of loan.
(Whichever is lower)

Nil 2% of Principal outstanding at the time of foreclosure and amount prepaid in last year, if any.

HDFC Bank

4% of Principal outstanding (after 6 months of availing loan, after payment of 6 EMI,s)
No prepayment allowed up to 6 months

Charges 6 % of POS for preclosures within 1 year from 1st EMI
5% of POS for preclosures within 13-24 months from 1st EMI
3% of POS for preclosures  post 24 months from 1st EMI
No foreclosure allowed within 6 months from date of availing the car loan

 No prepayments allowed in first 6 months
6 months - 5 years - 1.5% of original loan amount
5 years -10 years - 0.75% of original loan amount
> 10 years - No closure fee

State Bank of India

Prepayment after 6 months- Nil
Prepayment before 6 months-1%

2% of Loan prepaid, subject to certain conditions

No penalty if the loan is pre-closed from own savings/windfall gains for which documentary evidence is produced by the customer.


Source: Websites of respective Banks

Bankers Justification for Pre-Payment Charges:

1. Penalty for contractual Breach:

Pre-Payment penalty is to discourage the contractual breach and to compensate the lending entity for a loss in case, the customer still wants to walk out of the deal. There is an understanding to this effect between the lender and the borrower who chooses between a fixed and floating interest rate. Whatever, may be the reason for prepayment, it will be one party gaining at other cost, in the name of consumer choice.

2. Holding Cost of Funds:

Banks also need to charge for the holding cost of funds. When a customer pays back the entire loan amount, they need to hold this amount for some time before it can be invested elsewhere, and fetch a return on that investment.

3. Associated Costs to the Lending Entity:

Acquiring a customer entails a cost to the bank. For instance, in case of car loan, fees paid to the car dealer or the Direct Selling Agency (DSA), is nearly 3-5%. When the customer prepays, in say, 6 months, the total cost for the bank comes to as high as 8-10%.

4. Loss of  Money, as well as Client to a Competitor:

It would be un-realistic to be expected for a bank to oblige the customer to the extent of enriching their own business rivals. Banks, after all, are always on the look-out for better profit margins to survive and thrive.

The Customers Angle:

The basis of a free market is Fair Competition. Banks are always on the lookout for attracting new customers and retaining the existing ones.

The two major reasons for prepayment by the customer are:

I. Spare Money

II. Refinance of Loans

As regards the first case, where the customer prepays on account of spare money he has, it is important to note that many banks waive the penalty when the customer prepays from his own pocket.

When the reason is refinance, Banks will, understandably reluctant to loose customers, who wish to refinance their loans by availing lower rates of interest being offered by other banks. However, the way to retaining them is by offering competitive rates.

Banks attempt to limiting consumer's choices through financial disincentives is unfair, revenue losses notwithstanding.

Financial market is highly unexplored in India and by scrapping prepayment charges, banks are likely to attract more customers.

Reserve Bank of India,s contradictory stand on Pre-Payment Penalties charged by Banks

" RBI does not approve of charging foreclosure charges. We have...... advised banks to lay out appropriate internal principals and procedures, so that usurious interests, including processing and other charges are not levied by banks on loans and advances."

"In the context of greater of greater functional autonomy to banks, operational freedom has been given to scheduled commercial banks on all matters pertaining to banking transactions, including foreclosure of loans"

- Reserve Bank of India- Replying to a Query filed under the Right to Information Act.

Prevailing Practices: 

* Axis Bank does not charge pre-payment penalty for home loans, since it lowers the risk of default if the person is willing to pre-pay.

* No Penalty is charged for the part-payment of the loan by banks, in general.

* Generally, penalty is waived, if the borrower pre-pays from his own pocket.

* Even Co-operative banks, charge a penalty for prepayment in case the entire loan is being refinanced.

* Prepayment is reduced in case of customer's having good credit track.

* For Educational Loans, few banks even offer an Incentive on Pre-payment.

Global Practices:

The system functions differently in many countries. In the US, for example, the consumer is given wide range of options to choose from.

* If the customer wishes to avail of lower interest rates, he has the option of signing on to a pre-payment clause, OR

* He also has the option of going for terms that offer standard rates and no penalty for refinancing.

National Consumer Disputes Redressal Commission:

The National consumer Disputes Redressal Commission has already taken on banks over this issue. In an ongoing case, the commission has termed the practice of charging prepayment penalty as an unfair and restrictive trade practice and charged penalty on the bank. The matter now lies with the Supreme Court, with an appeal being filed by the concerned bank on the ground of the freedom being exercised on the basis of operational freedom.

Conclusion:

RBI has surely questioned the practice of banks slapping penalty charges on pre-payment of loans, saying it did not approve of such charges. However, it stepped back from its role in actually enforcing its point of view. It has admitted that it had received complaints on charging of penalty on premature payment of loans by banks, who have been "suitably advised"

However, in these cases, the need of the hour is for the RBI to move out from its advisory role to the role of regulator and making it a mandatory requirement.

Clear cut guidelines from RBI in this hitherto untouched area, would be more than welcome.

References:

1. Times View/ Counterview, RBI against Loan Prepayment Penalties, September 24, 2009 - Ratna Goswami.

2. Websites of respective banks for applicable rates of foreclosure charges.
 


Dr. Vikas Trivedi
Lecturer
CZ Patel College of Business and Management
Vallabh Vidyanagar (Anand)
 

Source: E-mail March 17, 2010

          

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