Prepaying loan? Beware non-tariff barriers

Most consumers who borrow for the first time are incredulous when they are told about prepayment charges.

“What? Pay for repaying before time?” they would ask.
But believe it or not, the levy has valid economic rationale.

First, since the lenders themselves borrow from the market to lend to consumers, they are themselves bound by a contract to continue to pay the contracted interest rate to their lenders notwithstanding the prepayment received from the consumer. The prepayment charge reimburses to the lender the costs incurred due to the fact that there could be a delay between the time the money is received from the prepaying consumer and is re-lent to another consumer, and also for the fact that it could be re-lent at a lower rate than what the pre-paying consumer was paying.

Second, lenders incur a lot of upfront costs on the loan (much higher than the upfront fee the lenders may charge) that they hope to defray over the tenure of the loan. Any prepayment tends to interfere with this recovery of costs and hence prepayment charges are justified in recovering this loss.

Third, the lenders package a number of retail loans and sell them in the market to investors (this process is called securitisation).

These investors typically look for a steady flow of future cash flows, which could be disrupted due to prepayment. The investors keep a buffer for prepayments and hence such loans where prepayments are expected cost the lenders more money to sell. The cost of such prospective securitisation is one of the elements that go into pricing the loan to the consumer and hence if the prepayment charge was not there to discourage prepayment, the loan would
ab initio be more expensive for all borrowers.

Again, internationally prepayment charges are a norm.

Most forums —- whether they are regulators or courts or the Competition Commission of India —- have in various contexts already allowed the practice of charging prepayment penalty.
Only the National Housing Bank (the regulator for housing finance companies such as HDFC, LIC Housing Finance Co, etc) has issued a circular, dated October 18, 2010, asking the housing finance companies not to charge borrowers any prepayment charge if the prepayment is “from their own sources.” This sounds slightly ambiguous since it has not defined what constitutes “own sources” or how the proof will be provided.

“The ‘own sources’ referred here should be illustrative in nature where funds coming from sources like salary arrears, bonuses, disposal of land and selling of jewellery, etc are covered. If a customer is borrowing monies from relatives, friends and spouse, or has shopped for a cheaper loan from some other lender, then he is defeating the purpose,” says R S Garg, general manager, department of regulation & supervision, National Housing Bank.
So why does the issue of prepayment charges get so much attention?

That is because it is inextricably linked to the issue of unfair floating rates that lenders charge to existing consumers compared with what they themselves give to new consumers (see the article ‘Of wives, girlfriends and home loans’ in DNA Money, February 7, 2009). When consumers are being charged an unfair interest rate, it is natural that they would feel even more cheated when they have to pay a fee to shift to a lower rate (no matter how justified the charge).

Unfortunately, the focus is on the wrong place. The focus should be on the non-tariff barriers lenders erect to prevent consumers from shifting the loan to a new lender. The new lender needs a lot of cooperation from the existing lender in terms of giving certificates for documents held by them as security and the amount due on the existing loan, etc. The existing lenders, for obvious reasons, are not very cooperative. Now, if only like Telecom Regulatory Authority of India, the regulators concerned (RBI and NHB) laid down the framework and rules by which loans can be ported from one lender to the other simply by sending an SMS to a short code. I am sure the consumers would not mind paying the portability charge (prepayment charges) though it is considerably higher than the Rs19 charged for mobile number portability.

The writer is CEO, Apna Paisa, a price & features comparison engine for loans, insurance and investments. He can be reached at hrdna@apnapaisa.com