Penalty on Pre-payment of Home loan on floating rates is removed for HFC for Banks, wait!


The banks thrive on the margins between deposit rates on deposits accepted from customers and loan rates on loans given to the needy. Normally, the margin is 3 ot 4%.(NIM) From this margin, banks have to manage all their administrative  and other expenses and also get some profit for the pain taken for these transactions. But nowadays, the competitive deposit rates accepted is around 10% and hence the banks can lend to public at an interest rate of more than 13%. Due to competitive atmosphere in lending business, sometimes banks get interest margin on loans 2% only and hence in order to jack up it to 3%, banks devised many new charges on customers . Prepayment penalty is one the charges
levied by Indian banking system. This charges varies from bank to bank and it ranges from 1% to 3% of outstanding loan amount.

Definition of pre-payment charges: It is 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. This charge compensates the lender for the loss of interest that bank would have earned , had the loan remained as per the original agreement till its complete repayment as per agreement.

Why clients wants to repay earlier:

The clients when they have surplus money want to clear the debt so that they can reduce the interest amount payable which is going up fast. Also due to increase in interest rate, the EMI is also going up and many clients are unable to pay the EMI. Though banks allow increased repayment period in order to keep EMI constant, Banks are in problem when the loans repayment period is already long i.e. more than 25/30 years. Refinancing of loans at lower rate and good service by other financial institutions encourages clients to think of pre-closing their loans with the existing banks.

 Banks justify this levy by following points:

  1. Breach of contract and hence penalty: Banks based on past trends of deposit determine how much to lend. Since deposits are received for various periods right from 15 days to 5 years or more i.e. short term and long term,  banks are planning to lend the money received for short term and long term. If any mismatch is there between deposits and loans, then banks will be loser as either it has not fully utilized the  deposits properly or it has to take loan from other banks/RBI to bridge the gap between deposits and loans which is costly. In lending, banks have three types now: 1.Fixed rate 2.Floating rate 3.Teaser rates. In Fixed rates and teaser rates,  banks may lose if deposit rates increases. In floating rate, the rate can be  revised upwards which safeguards the profitability of banks. But banks are  charging penalty on pre-payment irrespective of any type of lending. Of course  some banks are allowing prepayment of loans with loanee’s own earned money.Holding  surplus funds due to pre-payment:
  2. If any loanee pre-pays the  loan, then banks needed some time to find another needy for lending. For this  time gap, banks levy the charge. Ofcourse, there are many avenues for keeping  the surplus funds but it carries less interest rate.
  3. Not  letting the clients to go to other banks: Penalty for pre-payment discourages clients to switch over to some other  banks. This helps banks to retain customer base intact. Losing customer costs bank heavily by way of fees to agencies to procure business or loss on  incentives spent for creating new customer base/retaining existing customers.
  4. To save costs: Nowadays, banks are depending on Direct selling  agency(DSA)for lending business. They are paying fees ranging from 1% to 3% to  DSA on the amount of loan lent to the clients procured by DSA.  If the concerned clients prepay the loan in  shorter period, then this cost of fees cannot be covered except by way of  penalty.
  5. To insure safety of funds: Due to inflation and increase in  EMI, there is chance of losing money as many clients fail to repay the loans. At  least these type of charges on all loans will safeguard some % of losses.
  6. Increase in Repo rates/CRR: The concept of penalty on pre-payment came when RBI  started increasing the Repo rate and Cash Reserve ratio.  Repo rate is the rate at which the central  bank lends money to bank. CRR is the % of cash to be kept in RBI based on deposits. Since repo rate is paid by banks to RBI to get funds from RBI when  they are short of funds but promised clients to give loans and mismatch of  deposits vs loans.

What is the present position:

The competition commission of  India, based report of Director General (Investigations) has taken up the case  with Govt/RBI/NHB against banks for misusing their dominant position in lending  when clients in need of money and entering into anti-competitive agreements.

The National Housing Bank(NHB), which is the housing finance regulator, in a circular asked all housing finance  companies not to levy any pre-payment charges or penalty on floating loans if  the loan is pre-closed by the customer through any funding source. But it is  not fully agreed by Housing finance companies. NHB made a distinction of loans  among fixed and variable and favoured exemption from payment of penalty only to  floating rate loans. For fixed rate loans, it asked the banks to waive penalty  if they pay from their own resources. If refinance method from other banks are  attempted for fixed rate loans, then penalty can be levied. NHB has also asked  housing finance companies to apply uniform interest rate whether it is old  customers or new customers as risk profile is same in both group. Charging of  higher interest from old customers against new customers puts them to a great  disadvantage, besides being discriminatory. The practice also generally lacks  in transparency and fairness and banks should desist from this.

On 19.10.2011, NHB has issued directive to all housing finance companies for which it lends money not to levy penalty on pre-payment of home loan.NHB regulates 54 HFCs, including  HDFC, LIC Housing Finance and Dewan Housing Finance.

“Floating rate loans: According to NHB’s circular, HFCs can’t charge a prepayment penalty from customers whose loan is on floating rates even if money used to prepay the loan is borrowed from a bank or a non-banking finance company (NBFC).

Fixed rate loans: Even customers on a fixed interest rate  won’t be charged a penalty if they are prepaying from their own sources. However, if they  borrow from a bank or NBFC, they may be subjected to a penalty, depending upon the HFC’s terms and conditions.

Fixed-cum-floating rate loans: If customers have a fixed-cum-floating rate loan, the rules for fixed loans will apply till the time their loan is fixed and then the rules for floating loan will apply. In other words, if customers don’t want to pay a penalty,they will have to prepay from their own sources till the timetheir loan is on a fixed rate; thereafter, they may pay from any source of income for floating part  and still not pay a penalty”.

RBI has to take steps to cover banks for this  step. To improve customer service in the  banking industry, RBI has released 10 point action plan as a sort of  recommendation in the Banking Ombudsman conference.  One of the recommendations is that banks must  stop enforcing pre-penalty clauses on customers seeking an early end to their  indebtedness. “Banks must not recover pre-payment charges on floating rate  loans. Floating rate loans pass on the interest rate risk from banks to  customers. Banks only substitute interest rate risks with potential credit  risks,” the release said. Banks may also offer long-term fixed rate housing  loans to their customers and address their asset liability mismatch (ALM)  issues by recourse to the Interest Rate Swaps (IRS) market. This recommendation  of RBI will be transferred into directive if banks are not taking steps to  correct their position in respect of penalty on pre-payment of loans.

The Supreme Court will, in an appeal filed by the State  Bank of India against a National Consumer Disputes Redressal Commission order, decide whether it is right for banks and housing finance companies to charge  pre-payment fees on customers repaying loans ahead of their tenure.

The Commission had, in a recent case ruled that prepayment clauses are  restrictive trade practices, which restrict the consumers’ right to avail loans  at a lesser rate of interest. It called upon the country’s largest bank to  refund the Rs 40,000 it had collected as pre-payment charges from Usha Vaid,  who had shifted to another bank. The forum said it appeared that this amount  was charged as punishment to the consumer who sought transfer of the loan amount  to another bank, giving a lower rate of interest.

The Home loan customers are eagerly waiting for the  verdict of Supreme court in the above case. RBI may like to act positively  before verdict of Supreme court in order to keep its name as regulator. Already  the leading Bank SBI has withdrawn pre-payment penalty on home loans on all floating rate home loans.

C.R. Venkata Ramani

(AICWA)

Previously worked as Cost consultant with Dun&Bradstreet, Chennai on contract basis for working out profitability of  one overseas bank

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3 thoughts on “Penalty on Pre-payment of Home loan on floating rates is removed for HFC for Banks, wait!

  1. RBI released its quarterly review policy on 25.10.11 wherein it increased repo rates by 0.25%. In that circular, RBI indicated about the penalty on pre-payment of home loans:
    “The Reserve Bank of India has also proposed to notify banning prepayment penalty on floating rate home loans, as recommended by the Banking Ombudsman recently.”.So RBI is towing the line of NHB .

  2. Today (25.10.11 news)\
    Heads of banks from SBI to Bank of Baroda are likely to tell RBI in pre-monetary meeting that if it enforces waiver of pre-payment penalty on home loans, interest on home loan will increase by 1.5% in order to make up for the losses on all bank loans. One bank suggests for giving this facility to only self occupied housing property and not for investors in housing properties.Thus banks exhibit their desire not to lose easy money. But this type of attitude will leave enough ground for home loan takers to switch over to housing finance cos supervised by NHB and thus sizable business will be lost. RBI and NHB say that only on floating rates, this levy should not be there as all housing finance companies and banks have the leverage in increasing the rates for floating home loans. Since this income is very meagre on floating rate loans, banks should not increase their rates and absorb it by increasing the exposure. Increasing the rates will make banks to go bankrupt soon as NPA will rise enormously and as per RBI directive to make provisions for bad debts, banks will be in soup to justify their performance before their shareholders. It is right to say that banks are probably blowing out of proportion their potential loss if they waive pre-payment penalty

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