Ending prepayment levy to benefit borrowers

An advertisement recently drew my attention where a lady is heard telling her banker, “Oh! paise dene ke bhi paise dene padenge.” Indeed, she was referring to the pre-payment penalty on the loan she had come to repay.

The Reserve Bank of India (RBI) has proposed that the banks should not levy any prepayment penalty on floating rate loans. Though banks had initially agreed, recent media reports mentioned that Indian Banks’ Association (IBA) has made a U-turn and urged that the proposal for waiving of prepayment charges be withdrawn.

The reason cited by them is that when a borrower repays the home loan it results in a mismatch of assets and liabilities. Similarly, banks penalise the customers who go for premature withdrawal of their fixed deposits with banks. The logic of mismatch of assets and liability due to prepayment of loan or premature withdrawal of fixed deposits can be understood in case of fixed loans. But this logic of mismatch cannot be stretched to floating loans as the banks are free to raise the rate of interest on floating rate loans if there is any rise in the cost of present borrowing.

The prepayment penalty was supposed to cover the cost of rebalancing the mismatch caused due to prepayment made by the borrower.

This logic may seem convincing to some extent in respect of full tenure of the fixed rate loans. Major chunk of lending by the banks where the differentiation of fixed and floating rate is prevalent, is done towards home loans. However, presently there is hardly any home loan product available which is fixed for its entire tenure. The one I know of is by Axis Bank which was launched recently. So there was convincing logic for levying prepayment penalty even in the case of the loans which are fixed for a few years. Thus, waiver of penalty on prepayment of home loans taken on floating rate is overdue and should not be further postponed. As the home loans are of higher amount and longer tenure, the prepayment penalty hits hard.

More than 80% of the home loans are under floating rates and banks have been adjusting the impact of rate variation through change in the lending rate of the loan .There has never been any justification for levy of prepayment charges on such loans. Since prepayment of loans in case of floating rates did not involve any mismatch of assets and liabilities in the balance sheet of the banks, the levy of the prepayment charges made till date by all the lenders have been without justification and the banks have unduly enriched themselves at the cost of home loan borrowers. Since the amount so collected cannot be refunded now, at least the bank should extend the facility of non-levy of prepayment charges on all the existing loans as well though some banks have proposed not to levy prepayment charges on fresh loans advanced.

National Housing Bank (NHB), which regulates housing finance companies, has already issued instructions to its constituent members not to levy any prepayment penalty if the repayment is made from own sources of the borrower. In my opinion, the condition of funds to come from own resources is not justified and throttles fair competition amongst lenders. Therefore, even NHB should expand the scope of its circular so as to do away with differential of source of money and advise its members not to collect any prepayment penalty altogether.

The primary aim of the RBI in regulating banking sector is to safeguard interest of general public and not to advance the interest of the banks. The existing practice of prepayment penalty is a hindrance if a customer decides in favour of making prepayment. This in turn deprives the borrower the opportunity to take the benefit of better rate being offered by any other lender, since the amount of prepayment penalty negates the benefits which a borrower could get due to difference in interest rates.

Telecom regulator has already allowed the mobile phone subscribers to move to other subscriber without losing their existing mobile number at very nominal cost and similarly Insurance Regulatory Authority (Irda) has also allowed portability for health insurance. Since two of the regulators have already allowed portability, the RBI should also allow this portability of loan from one lender to another lender in case of all loans. However, this portability needs to be implemented at least in cases of floating rate loans. However, exception can only be there in cases where the loans have been given for fixed rate for entire tenure and banks may have to incur some costs to rebalance their assets and liabilities in case of any prepayment.

We have experienced that competition improves level of services as well the costs as is evident from services in telecom sector, insurance sector and postal sector etc. Removal of prepayment penalty will benefit the customer in the long run in terms of cost and services. Moreover, due to the portability being available anytime, the benefit of service and lower costs will not only be available at the time of taking the loan but also throughout the tenure of the loan. All the borrowers will surely appreciate this gesture of RBI if it allows complete portability of loans of all types without any substantial costs attached with it.

Even the competition commission had upheld the levy of prepayment charges only on the basis that the same is as per the agreement entered into between the lender and the borrower and not from the competition point of view. Levy of prepayment charges throttles the competition and deprive the consumer to reap the real benefits of competition.

Let the RBI not heed to the request made by IBA to withdraw the proposal to waiver of prepayment penalty on floating rate loans and give way to fair competition amongst the banks and improve the consumer experience.

The writer is CFO of ApnaPaisa.com,
a price comparison engine for loans, insurance and investments.
He can be reached at balwant.jain@apnapaisa.com.