Personal Finance

Bid a happy farewell to prepayment penalty

Adhil Shetty | Updated on April 23, 2011 Published on April 23, 2011

SBI has let go of these penalty charges and there is hope other banks will follow suit.



The country's largest bank SBI announced last week that it will be dropping the ‘prepayment charge' on its loans.

This announcement came the next day after it hiked its base rate for lending by 0.25 per cent. It also withdrew its teaser loan schemes along with this announcement. So what are the implications of this move?

As home loans typically run their course for 15-20 years, the borrower may find that a lot can change over the term of the loan - interest rates, the size of the monthly instalment and even capacity to repay the loan.

A borrower may choose to “pre-pay” a loan or close it out before its term. Most banks impose a penalty on such prepayment. Prepayment can be charged in two cases. One, when you prepay with your own sources. In this case, you issue a cheque from your own account. Second, you refinance the loan by transferring it to another bank.

Impact of prepayment

The prepayment penalty usually stipulated by public sector banks is about 1 per cent or less of the loan outstanding, while it can be anywhere between 1-3 per cent 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 Rs 20 lakhs of loan outstanding, the penalty could range from nothing to Rs 60,000 depending on the bank.

Now, when it comes to figuring out your outstanding loan amount do not assume that if you have taken a Rs 40 lakh loan for a 20-year tenure and you are halfway through it, you would have paid Rs 20 lakh.

Here is why. During the initial years of repayment the interest component makes up a larger portion of your EMI (equated monthly instalment) and during the latter years the principal component is higher.

So if you are indeed halfway through the term of your loan, you would have repaid the interest component for the most part.

Banks do this to retrieve their interest cost or fee for the loan upfront before obtaining the actual loan amount (principal) borrowed.

To determine how exactly the repayment happens throughout the tenure of your loan, use can use the EMI calculators and amortisation tables available on websites such as www.bankbazaar.com.

However, do note that when you prepay a loan, unlike EMIs, it directly 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, pre-payment maybe worth it if you actually save a significant amount of interest by re-financing the loan.

Points to note

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 per cent if you prepay before 5 years, 1 per cent between 5 to 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 importantly, 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.

The RBI has shown its displeasure in the past about the practice of banks levying prepayment charges and has been advising the banks against it.

However, in the recent turn of events where SBI has actually dropped prepayment penalty charges there is hope that other banks might follow suit.

Also, it may be worth mentioning that another body, owned by the RBI, the National Housing Bank (NHB) directed the banks in October 2010, with immediate effect, not to charge prepayment penalty when the borrowers pay off loans with their own sources.

Violation will lead to action under the National Housing Bank Act, 1987, it said. The one page directive is available at http://nhb.org.in/Regulation/scan0019.pdf.

This directive, however, doesn't say anything about refinancing. It remains to be seen if State Bank of India's recent move has a ripple effect, which can usher good news for borrowers.

(The author is CEO of www.bankbazaar.com, an online marketplace for loans)

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