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