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Pre-Payment Penalties – Regulatory Review the Best way forward*
Posted On: 2020-02-14 Author : R.S. Garg

1. Prepayment penalty or levy or charges or foreclosure charges by whatever name called is a pre-agreed amount between a borrower and a lender which the borrower is required to pay to the Lender in a borrowing arrangement in case the borrower decides to repay the loan before the agreed period. This is to compensate the lender for the loss likely to be suffered by him on account of such pre-payment by the borrower. Though called a ‘penalty’, the amount agreed should be reasonable and of compensatory nature for the loss or damage likely to be suffered by the Lender due to such prepayment by the borrower. In case the amount agreed is unreasonable, it will be regarded as unconscionable contract, liable to be declared unenforceable and void by the Courts.

2. However, there were lot of dissatisfaction and grievance amongst the borrowers particularly in the home loan segment against the home loan providers, may that be a bank or a housing finance company, against such levies. Root cause of such complaints was the unreasonable nature of the amount collected by some of such lenders, which virtually deprived the borrowers to avail loans at lower rates of interest in a falling interest rate scenario. Home loan borrowers getting large amounts at the time of their retirement, inheritance, or sale of some other property etc. also resented payment of such levies, while prepaying their loan obligations. Additionally, with the introduction of fixed and floating rates of interest, it was expected that the lenders also have the opportunity to adjust to the market dynamics in case of pre-payments and should not collect any amount by way of pre-payment penalties.

RBI Instructions on Pre-payment penalties
3. RBI has been considering reasonableness of bank charges from time to time. It had issued a circular dated February 2, 2007 in this context to the Banks. On May 26, 2010, RBI constituted a Committee to look into banking services rendered to retail and small customers and to suggest, inter alia, measures for expeditious resolution of complaints under the Chairmanship of Shri M.Damodaran. The Committee submitted its Report on July 04, 2011. In the said Report, in paragraph 2.3.4, the Committee discussed Home Loan Issues and noted as follows :

“Foreclosure charges levied by banks on prepayment of home loans are resented upon by home loan borrowers across the board. Banks are also found to be hesitant in passing on the benefits of lower interest rates to the existing borrowers in a falling interest rate scenario. As such, foreclosure charges are seen as a restrictive practice deterring the borrowers from switching over to cheaper available source. This is especially so when some banks are offering lower interest rate benefit to new customers, also the floating rate is anchored to an internal rate.” The Committee recommended that “ Banks should not impose exorbitant penal rates towards foreclosure of home loans and a policy should be devised to ensure that customer is not denied the opportunity to enhance his economic welfare by making choices such as switching to other banks/financial entities to enjoy the benefits conferred by market competition.”

4. One of the action point to improve Customer Services of banks decided at the Annual Conference of Banking Ombudsmen held on September 5, 2011, was that Banks must not recover pre-payment charges on floating rate loans. Banks may also offer long term fixed rate housing loans to their customers and address their asset liability mismatch (ALM) issues by recourse to the interest Rate Swaps (IRS) market. Floating rate loans pass on the interest rate risk from banks which are much better placed to manage it to borrowers and, thus banks only substitute interest rate risk with potential credit risk. The bank will, however, be free to recover /charge appropriate pre-payment penalties in the case of fixed rate loans.

5. In its Monetary Policy Statement 2012-13, in paragraphs 81-83, RBI referred to the Damodaran Committee Report and proposed that banks will not be permitted to levy foreclosure charges/prepayment penalties on home loans on floating rate basis. Accordingly, by a circular dated June 5, 2012 RBI directed that the banks will not be permitted to charge foreclosure/ prepayment penalties on home loans on floating rate basis with immediate effect. It may not be out of place to mention here that while the instructions issued by RBI refers to Home Loan on floating rate basis and not to the borrowing entity, the context in which it was issued was only small and retail borrowers.

6. In its first bi-monthly monetary statement of 2014-15 dated April 1, 2014, RBI was of the view that consumer protection is an integral aspect of financial inclusion. By its Circular dated May 7, 2014, following the said Policy Statement, and in the interest of consumers, RBI advised the banks that, they will not be permitted to charge foreclosure charges/prepayment penalties on floating rate term loans sanctioned to individual borrowers with immediate effect. It may be noted that this Circular does not distinguishes between an individual borrower who has obtained term loans for business purposes or otherwise. Thus, earlier restriction of such advisory being only on home loans also was done away with.

6.2 However, by its Circular dated August 02, 2019, RBI clarified that banks shall not charge foreclosure charges/prepayment penalties on any floating rate term loan sanctioned, for purposes other than business, to individual borrowers with or without co-obligant(s).

7. Vide its circular dated July 14, 2014, RBI advised NBFCs not to charge foreclosure charges/pre-payment penalties on all floating rate term loans sanctioned to individual borrowers, with immediate effect, with a view to bring uniformity with regard to prepayment of various loans by borrowers of banks and NBFCs.

7.2 To maintain uniformity in this regard between Banks and NBFCs, RBI vide its Circular dated August 02, 2019, RBI clarified that NBFCs shall not charge foreclosure charges/prepayment penalties on any floating rate term loan sanctioned, for purposes other than business, to individual borrowers with or without co-obligant(s).

7.3 Thus, no prepayment penalty can be charged by a bank or NBFC on the floating rate terms loans granted to the individual borrower with or without co-obligant(s) where the loan is sanctioned for purposes other than business.

NHB Instructions on Pre-payment Penalties
8. National Housing Bank (NHB), the regulator of housing finance companies (HFCs) has also issued instructions on pre-payment penalties from time to time. Vide Circular dated October 18, 2010, NHB advised that pre-payment levy should not be collected from the borrowers when the housing loan is pre-closed by the borrowers out of their own sources. Again on October 19, 2011, NHB advised that HFCs should not charge pre-payment penalty on pre-closure of housing loans under the following situations:

  • Where the housing loan is on floating rate basis (pre-closed through any source)
  • Where the housing loan is on fixed interest rate basis and theloan is pre-closed by the borrowers out of their own sources.

    The expression “own sources” for this purpose mean any source other than by borrowing from a bank/HFC/NBFC and /or a financial institution.

8.2 From the above, it can be observed that these instructions will be applicable depending upon the nature of loan and not depending upon the type of borrowers. Therefore, in case a loan is booked as a housing loan in the books a lending HFC, the instruction will become applicable.

9. NHB vide its Circular dated August 14, 2014 again reviewed the instructions on the subject keeping in view the developments in the case of banks/NBFCs based on the directions issued by RBI. Vide the said Circular, NHB as a measure of customer protection and also in order to bring uniformity with regard to prepayment of various loans by borrowers of banks, NBFCs and HFCs, advised that HFCs shall not charge foreclosure charges/prepayment penalties on all floating rate term loans sanctioned to individual borrowers. Thus, by the said circular parity was brought in the matter of pre-payment penalty on floating rate term loans to individual borrowers in the financial sector.

9.2 NHB vide its Circular dated September 3, 2014 clarified that loan in which company, firm, etc. is a borrower or co-borrower is excluded from purview of the Circular dated August 14, 2014. NHB vide its Circular dated July 22, 2016 further clarified as follows:

“Further, the issue relating to applicability of the aforesaid Circulars to a sole Proprietorship concern/Firm or an HUF, as a borrower/co-borrower has also been examined in the light of complaints/representations received by us. We clarify that the intent and spirit of the circular is to protect the interest of the individual borrowers. Therefore, a Sole Proprietorship Concern/Firm or an HUF, as borrower or co-borrower will not be treated as an individual borrower for the purpose of these circulars.”

Devendra Surana Vs. Bank of Baroda on “individual borrower”
10. The use of the words “individual borrower” in the circulars issued by RBI in this context was also taken to mean that it excludes proprietary concerns by banks. However, this aspect came to be examined by the Calcutta High Court (Appellate Side) in Devendra Surana Vs. Bank of Baroda &Ors inW.P.No.5521(W) of 2017.Vide its Order dated December 12, 2018, the Hon’ble Court held that “ A natural person and his sole proprietorship firm are the same legal entity. The liability of the sole proprietorship firm, is that of the natural person carrying on business under its name. The sole proprietorship firm of a natural person and the natural person owning the firm do not enjoy the benefit of being treated as separate legal entities. They are one and the same legal entities.”

10.2 Thus, what hold good in case of banks also hold good in case of HFCs and to such extent NHB instructions are clearly contrary to the said judgement, more particularly when NHB circular refers to the parity among banks, NBFCs and HFCs in this regard.

10.3 However, this position seems to have undergone a change vis a vis banks and NBFCs with the issue of further clarification by RBI to banks/NBFCs vide its letter dated August 2, 2019 where it has been clarified that NBFCs/banks shall not charge foreclosure charges/prepayment penalties on any floating rate term loan sanctioned, for purposes other than business, to individual borrowers with or without co-obligant(s) as proprietorship firms are formed by individuals for conduct of business.

RBI Regulator of HFCs
11. It may be mentioned that the Finance (No.2) Act, 2019 has amended the National Housing Bank Act, 1987 conferring certain powers for regulation of housing finance companies (hitherto exercised by National Housing Bank) with Reserve Bank of India. The relevant provisions have come into force w.e.f. August 09, 2019. Subsequently, on August 13, 2019, RBI issued a Press Release stating that :

“ HFCs will henceforth be treated as one of the categories of Non-Banking Financial Companies (NBFCs) for regulatory purposes. Reserve Bank will carry out a review of the extant regulatory framework applicable to the HFCs and come out with revised regulations in due course. In the meantime, HFCs shall continue to comply with the directions and instructions issued by the National Housing Bank (NHB) till the Reserve Bank issues a revised framework. ...”

11.2 It may also be mentioned that on November 11, 2019, RBI has sent a communication to all HFCs advising them of its decision to withdraw the exemption granted to HFCs from the provisions of Chapter IIIB of the RBI Act, 1934 and make it applicable to them except Section 45IA. However, the requisite notification under the RBI Act for withdrawal of such exemption is yet to be issued.

11.3 Thus, as on date the instructions issued by National Housing Bank with regard to pre-payment penalty are applicable to HFCs.

The Best Way Forward
12. The Circulars/clarifications issued by NHB referred as above does give rise to some ambiguity about the true intent and spirit on the issue of restriction on charging of prepayment penalties on floating rate loans by HFCs particularly when these instructions are to be on the lines of the one issued by RBI to the banks/NBFCs. The issue of joining or not joining of co-obligant(s) and the purpose for which the loan is availed by the individual need to be clarified. It will be in the interest of all i.e. borrowers and lenders, if the position is clarified further by means of a circular/clarification by Reserve Bank of India in this regard as has been done in the case of NBFC/banks. This will also avoid unnecessary litigation between the parties.

13. While on this, the position of HUF, which is akin to an individual in this regard also need to be reviewed and going by the spirit of this beneficial measure need to be included as being an entity entitled to such a relief.

14. The applicability or non applicability of NHB instructions on fixed rate housing loans paid out of own sources by the borrower also need to be reviewed and, if not applicable, post parity of the regulation amongst banks, NBFCs and HFCs, in the interest of customers re-introduced at least in respect of housing loans to individuals.