Penalty on pre-payment and foreclosure of home loan – a thing of past?

Ban on pre-payment and foreclosure penalty

At this time of steep hike in petrol price and heavy inflation, there is one good news to cheer about – the Reserve Bank of India has notified all the banks to stop charging penalty on foreclosure and pre-payment of home loan with floating interest rate with immediate effect. So far banks used to charge 2% to 5% penalty on outstanding loan amount. Now borrowers who have outstanding home loan and have some extra cash can consider the option of making pre-payment of loan or switch from the existing lender to another one without bothering about penalty.

What is pre-payment / foreclosure penalty?

As the name itself suggests, pre-payment penalty means penalty charged to the borrowers who pay back their loans before the earlier agreed upon period.

Why do banks charge penalty on pre-payment or foreclosure of loan? How does it affect the customers?

If you give loan to somebody and that person repays the loan much before the earlier agreed date, you become happy and you don’t charge him any penalty for doing so, right? Then why banks are keen on charging heavy penalty for the prepayment of loan? Because, banks earn heavy profit in the form of interest paid on loan (use the calculator and see yourself how much of the amount you paid goes towards principal amount and how much goes towards interest) and any disruption to this ‘expected income’ may be considered as an opportunity loss. So banks do not encourage the borrowers to prepay the loan by paying one big lump sum; instead they expect the borrowers to pay the monthly installments regularly which will earn them good returns in the form of interest. Another reason is to discourage their existing customers from moving on to competing lenders.

Banks shift the risk of change in economy and market condition to the borrowers by making the interest rate floating. So they increase the interest rate whenever they feel it is required and thus safeguard their interest. Although banks are expected to increase as well as decrease the interest rate on loans with market condition, it is the usual experience of many borrowers that banks seldom show any interest in decreasing the interest rate to the existing customers while offering the decreased rate of interest to the the new borrowers. Heavy penalty on pre-payment discourages / restricts the existing borrowers from going to other lenders.

In the absence of penalty, borrowers can freely switch between the lenders and can go for banks who offer lowest rate of interest (and better service too). This will safeguard the interest of the customer and enable them to expect high quality service and better rate of interest on their loans.

With NHB banning the pre-payment penalty practice earlier, borrowers do not have to worry about pre-payment penalty irrespective of whether they obtain their loans from HFCs or banks now. Although some banks have voluntarily abolished pre-payment penalty recently, this move by the RBI will ensure uniformity in practice across all banks / HFCs and borrowers can enjoy the fruits of competition among lenders in the form of reduction in interest rates.