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.

4 responses to “Penalty on pre-payment and foreclosure of home loan – a thing of past?

  1. Hey Poornima, my parents took a home loan of 12,75,000/- ,(16 years). Back in 2004 from XXX bank, the agent and the bank personnel told us that its a floating interest rate method, so whenever the interest rate increases or decreases, same will be applicable on our interest rates, and it started from 8.5 % in July’04 and the EMI being 12,170/-. Every few months the RBI used to make changes to the interest rates, and so according to the market rate our interest rate was being changed by the bank, accepted. But since 2010 there has been no change in the interest rate, and now they have forcibly included some MVRR into the calculation, which were never told about. At the time when we took loan we were not told about any such MVRR or xyz rate, we knew only about the home loan rate and it being variable. And we were not getting any re-payment schedule statement from the bank from past 2 years, so we contacted the bank about same, and we asked them how much more is the outstanding loan amount and we were shocked to know that we still have to pay 1143345/-, and if the same method is followed it will take 19 more years to finish it off.

    I spoke to the bank personnel over phone and told them they were cheating us by not being transparent, they cannot do this to us. My parents are illiterate and I was only 15 when my parents took the loan in 2004. After that I told them we will go to consumer court and sue them about the same. Then they called us continuously for 3 days, every time with a different offer. First they said they can give me 13 % interest rate, then next day 12.50 % and on friday they offered 11%, and when I asked them why they didn’t apply these rates before, they said they do it only if the customer asks, and also that I was eligible for lesser rates since 2010.

    I need your help in this Ms Poornima. Plz help us. We’re in financial crisis at the moment. Plz reply asap. Thank you.

  2. Namah Shivay, Haribol.
    Thank you for your valuable knowledge for my concern and for all regarding foreclosure of housing loan account.


  3. Hi,

    I have taken a home loan of 14 Lakhs from XXXX Bank. Current interest rates is 11%. Now I would like to transfer the same to some other bank (Say SBI) as they are offering at 10%. So, just want to know if IDBI still charges the Penalty on Balance Transfer.

Leave a Reply