Prepayment implies closing the loan earlier than planned. Most banks impose a penalty on prepayment.
The prepayment can be charged in two cases. One, 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.
Its impact
The prepayment penalty for public sector banks is about one per cent or less, while it can be anywhere between one per cent and three per cent in private banks. In many cases, banks do not charge any prepayment penalty if you prepay using your own resources.
The penalty is calculated on principal. Hence if you have a `20 lakh loan outstanding, the penalty could be anywhere up to `60,000 depending on banks.
When it comes to figuring your outstanding loan amount, for instance if you have taken a `40-lakh loan for a 20-year tenure, you can’t assume that you would have paid `20 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.
To determine how exactly the repayment happens throughout the tenure you can ask your lender to provide you with the entire repayment schedule otherwise known as the amortisation table.
Banks do this to retrieve their interest cost or fee for the loan up front before obtaining the actual loan amount (principal) borrowed. However, do note that when you prepay it directly reduces the principal amount borrowed.
So if you were to prepay in small amounts throughout the loan tenure chances are that 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 paying prepayment charges, if you are actually saving a significant amount in interest by refinancing the loan.
Key points
From the view point of banks, 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 two per cent, if you prepay before five years, one per cent between five to 10 years, 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 as mentioned earlier, you should also see if you can prepay partially. Most of the banks do allow partial prepayment up to a certain limit. For example, you can pay 3-5 extra EMIs in a year.
RBI’s position
The RBI has shown its displeasure in the past on prepayment charges and has been advising the banks against it.
However, there is another body, owned by RBI, called National Housing Bank that has directed the banks in October 2010 not to charge prepayment penalty when the borrowers pay with their own sources. Violation will lead to action under the National Housing Bank Act, 1987. You can take a look at the one-page directive at http://nhb.org.in/Regulation/scan0019.pdf [1].
This directive, however, doesn’t say anything about refinancing. The banks are opposing it. It’s likely that there could be a middle path between banks and the RBI where the prepayment penalty on refinancing will stay but with the reduced rate. The jury is still out.
(The writer is CEO of bankbazaar.com)
Links:
[1] http://nhb.org.in/Regulation/scan0019.pdf