Prepaying to cost Less

Home loan borrowers soon may not have to pay any penalty for prepayment of loans linked to floating rate of interest. Banks currently charge anywhere between 1% and 3% of the principal if customers want to pay back the loan amount before the tenure ends. However, for fixed-rate loans, banks will continue to charge the prepayment penalty. The removal of the prepayment penalty will make it easier for customers to shift loans to other banks if they get a better interest rate and, most importantly, increase competition among banks.

The RBI's recent banking ombudsman conference threw up a host of proposed measures to improve banks' customer service and has said that banks should offer long-term fixed-rate housing loans to their customers and address their asset-liability match issues by taking recourse to the interest rate swaps market. It pointed out that, currently, floating rate loans pass on the interest rate risk from banks, which are much better placed to manage such risk, to borrowers. The central bank has also asked the lenders to revive fixed-rate home loan products, which have become almost a thing of the past. It stressed that banks are increasingly focusing on floating rate schemes to protect themselves from interest rate fluctuations. Analysts say around 80% of the outstanding home loans are floating rate loans.

Last month, a committee headed by former Sebi chief M Damodaran had also suggested banning the penalty charged by banks on prepayment of loan, and various consumer groups have in the past urged the central bank to ban the practice by banks. Bankers say that by charging for prepayment, they can manage their asset-liability gaps better and stop borrowers from shifting to other banks. The central bank feels that lenders should be in a position to absorb the asset-liability mismatch as the cumulative prepayment is a small fraction of the overall loan portfolio.

Currently, some banks do not charge any penalty if the borrower pays from her own source of funds and does not take any fresh loan to prepay the existing loan. In some cases, no prepayment charge is levied on the borrower if she pays up to 25% of the principal outstanding in the first two to three years of taking the loan.

Prepayment done above that attracts a penalty of 1-3%, depending upon the bank and the initial clause set up in the agreement. In fact, in May last year, the government had advised public sector banks, the Indian Banks’ Association and the National Housing Bank not to levy prepayment charges when the loan amount is paid by the borrowers out of their own funds. If any prepayment charges are to be imposed on housing loans, it need to be reasonable and transparent and not out of line with the average cost of providing the services.

In a written reply to a question raised in the Rajya Sabha, minister of state for finance Namo Narain Meena said that public sector banks have reported that, by and large, they do not levy any prepayment charges when the amount is paid by the borrowers from their own sources. Own funds means money generated by the borrower from her personal source and not through borrowing from a bank or non-banking financial institution.

Financial planners say partial prepayment of a loan makes sense at a time when interest rates are going up. It will bring down the tenure or even reduce the monthly instalment. Typically, for a housing loan, borrowers start doing the prepayment after the fifth year of the advance. Some banks like ICICI Bank charge up to 2% of the outstanding balance plus service tax and surcharges in case of full prepayment.

According to the banking regulator, some banks even charge as high as 5% on foreclosure of loans.

Financial planners also advise that prepayment must be done from the borrower's own funds after setting aside money for emergencies. They also say borrowers often take a personal loan or a credit card loan to prepay a housing loan, which in the long run is much more expensive. “The priority of a borrower should be to repay unsecured loans like credit cards and personal loans where interest is high. On the other hand, a borrower gets a tax incentive on interest paid up to R 1.5 lakh every year on housing loan and the benefit is much more,” says Brijesh Damodaran, founder of Zeus WealthWays, a wealth management company.

Borrowers should also keep in mind that they can bargain with the bank for reducing the prepayment penalty rate if one has a good credit history. Even for a select few, the bank can waive the penalty depending on the competition among banks. Financial planners also suggest that it is better to do part prepayment regularly as some leading banks do not charge any prepayment penalty if the loan is prepaid partially. By doing this, they say, borrowers can not only save on the prepayment penalty charge but also save on high interest costs on the outstanding loan.

Source: Financial Express