A primer on prepayment penalty

Prepayment implies closing the loan earlier than planned. Most banks impose a penalty on prepayment. The prepayment can be charged in two cases. First, when you prepay with your own sources. In this case, you issue a cheque from your account. Second, you refinance the loan from another bank.

Impact of prepayment
The prepayment penalty for public sector banks is about 1% or less while it can be anywhere between 1% and 3% in private banks. In many cases, banks do not charge any prepayment penalty if you prepay using your own sources.

The penalty is calculated on principal. Hence if you have Rs20 lakh of loan outstanding, the penalty could be from 0 to Rs60,000 depending on banks.

Now, when it comes to figuring your outstanding loan amount, do not assume that for instance if you have taken a Rs40 lakh loan for a 20-year tenure, you would have paid Rs20 lakh in 10 years. Here is why. During the initial years of repayment, the interest component repaid is higher and during the latter years the principal component is higher. So in your repayment so far, you would have only repaid the interest component for the most part.

However, when you prepay it directly, it reduces the principal amount borrowed. So if you were to prepay in small amounts, throughout the loan tenure, chances are you will close your loan much earlier. Most banks allow you to partially prepay up to a certain limit without any penalty but when you prepay in full you are likely to incur the highest prepayment charge. However, it maybe worth it if you actually save a significant amount in interest by refinancing the loan.

Some points for banks and borrowers
From the banks’ point of view, they charge prepayment penalty as it impacts the future income of the bank. To ensure you get clarity on prepayment, you must discuss the clauses at the time of borrowing. Insist on getting a written note on all the clauses.

At the same time, discuss with the bank the specific prepayment penalty levied at different stages of the tenure of the loan as banks have different charges for prepayment at different timelines. For example, banks may charge 2% if you prepay before five years, 1% between five and 10 years and none beyond 10 years.

You should also discuss with the banks, the difference in charges on prepayment from your own sources and on refinancing from other banks.

Last and most important, you should also see if you can prepay partially. Most banks do allow partial prepayment up to a certain limit. For example, you can pay 3-5 extra EMIs in a year.

RBI and its position on prepayment penalty
The Reserve Bank of India (RBI) has shown its displeasure in the past on prepayment charges and has been advising banks against it. The larger discussion is still on.

However, in October 2010, another body under the RBI, called the National Housing Bank (NHB), directed the banks, with immediate effect, not to charge prepayment penalty when borrowers pay with their own sources. Any violation of this directive leads to action under the National Housing Bank Act, 1987.

But this directive doesn’t say anything about refinancing. The banks have been opposing it tooth and nail. It looks likely that there could be a middle path between banks and the RBI where the prepayment penalty on refinancing will stay but with reduced rate. The jury is still out.

The writer is CEO, BankBazaar.com, an online marketplace for personal, home and car loans