Kolkata: Mr Amarjit Singh has taken a personal loan of Rs 10 lakh from bank A at an interest rate of 16 per cent. With RBI having reduced rates and lender banks passing on a portion of that cut to borrowers, other banks are contacting Mr Singh almost every day with loan offers at lower rates. When he talked to bank B, the loan offered was at 13.75 per cent interest. That would have been a good saving for Mr Singh on his EMIs. The fresh cheaper loan looked good till he found out that bank A would be charging a hefty pre-payment fee on closure of his existing loan. Financial advisors and experts say prepaying a loan is good for customers, but not for the bank. In fact, levying of prepayment charges is primarily to deter borrowers from switching to other lenders who offer lower rates.
Tough situation
Here's the maths. For a four-year loan of Rs 10 lakh at 16 per cent interest, Mr Singh's EMI is Rs 28,287. After having paid 12 EMIs, his loan outstanding is Rs 8.06 lakh. If he shifts to bank B offering a three-year term loan at 13.75 per cent interest, his EMI works out to Rs 27,245. That’s a saving of Rs 1,042 a month and a good Rs 37,512 for the entire loan period. However, his existing lender (bank A) charges 4 per cent on the outstanding as prepayment penalty, which is Rs 32,240. Effectively, it wipes out the interest arbitrage he would have got due to lower rates offered by another bank. This case is just not limited to one individual. In future, Mr Singh and others may want to avoid banks which charge hefty fees for prepayment.
BankBazaar CEO Adhil Shetty says that the prepayment fee is an additional amount that you would need to pay to the bank when you are repaying a loan before its actual maturity period. This fee usually works out to anything between 0.5 per cent and 2 per cent (sometimes even up to 5 per cent) of the principal outstanding at the time of loan closure, and it varies with banks and loan types. “Most banks charge prepayment fees only for full repayment, whereas charges are applicable for partial payments too. The RBI has allowed prepayment charges on home loans for only fixed rate schemes. Banks borrow money at a lower cost and lend it to customers it at a higher rate of interest. This difference is the bank’s earnings while lending money to customers. If a customer decides to prepay the loan, there’s saving on ?interest outflow. But at the same time, banks lose the interest they would have earned over the full loan tenure," he said.
Banks seek compensation for loss
Banks usually charge prepayment fees to compensate for this loss of potential revenue. "In other words, prepaying a loan is good for customers, but not for the bank. As banks cannot restrict customers from prepaying loans, levying prepayment charges is the way by which they look forward to compensate their loss to some extent," avers Shetty. The levying of prepayment charges is also to deter borrowers from switching to other lenders who offer lower rates, according to Shetty.
Naveen Kukreja, MD, Paisabazaar, is of the same view. "Initially banks and lenders used to charge prepayment penalty on both fixed and floating rates. Later, they stopped charging penalty if the prepayment was done through the borrower’s own funds to ensure they are not losing out in the process, as in case of home loan balance transfer. Now, RBI has mandated that prepayment penalty cannot be charged in case of floating rate home loans, irrespective of the source of funds. Banks levy prepayment penalty on fixed rate home loans primarily because prepayment of loan leads to loss of interest for the lenders," Kukreja said. He argues that sanctioning loans to consumers invoke certain costs and while part of it is transferred to the borrower, some of it rests with lenders. "This loss is primarily covered in the interest amount earned during the tenure of the loan. Also, interest earned on fixed rate is higher than what’s typically earned on floating rate. Foregoing it would lead to financial loss for banks and money lenders," he stated.
This won’t applicable in case fixed rate loan is switched to floating rate post completion of the tenure wherein the rate was locked-in as fixed, he added. Rishi Mehra, co-founder, deal4loans.com says that borrowers must look at the problem of banks. While borrowing the money and lending it to other customers, banks ensure that there is no asset-liability mismatch. For banks, loans given are assets and deposits taken from customers are liability. The asset-liability mis-match can be that of interest rates, maturity or currency.
Discouraging borrowers from shifting
"The pre-payment penalty is in place largely to check the negative impacts of maturity mismatch of assets and liabilities. When banks borrow for a certain period, it also wants to lend the same money for a tenure that is similar to maturity of the deposits. Banks would not want to have a situation where there is higher proportion of short-term assets but low long-term liabilities or vice versa. This could lead to liquidity as well as interest rate risk for the bank," Mehra said. Imagine a situation where bank has large short-term liabilities and low short-term assets. This would lead to a situation where the bank may find itself in a liquidity crisis as short-term deposits up for redemption are much higher the short-term loans.
"Also, the change in rates of deposits is much faster than that of loans. If there are many short-term deposits, and every time they mature and are rebooked, the rate of deposit may have changed but the change in interest rates of loans is not that frequent. In many cases, the rate of loan may remain fixed. This creates interest rate risk for the bank," he says.
