Pre-payment Charges : The Price For Home Loan Portability

Most consumers who borrow for the first time are incredulous when they are told about pre-payment charges. “What!! I need to pay a charge for paying up my loan before time?” This unbelieving tone has been heard many times from first time loan consumers.

But believe it or not, the levy of charges on pre-payment (banker speak for paying off your loan before it is due) has a valid economic rationale. The biggest one is that lenders themselves borrow from the market to lend to the consumer. They themselves are bound by contract to continue to pay the contracted interest rate to their lenders notwithstanding the pre-payment received from the consumer. The pre-payment charge reimburses to the lender the costs incurred due to the fact that there could be a delay between the time the money is received from the pre-paying consumer and is re-lent to another consumer and also for the fact that it could be re-lent at a lower rate than what the pre-paying consumer was paying.

Other logic is that lenders incur a lot of upfront costs on the loan (much higher than the upfront fee that the lenders may charge) that they hope to defray over the tenure of the loan. Any pre-payment tends to interfere with this recovery of costs and hence pre-payment charges are justified to recover this loss. Besides the lenders package a number of retail loans and sell them in the market to investors (this process is called securitisation).

These investors typically look for a steady flow of future cash flows, which can be disrupted due to pre-payment. Naturally the investors then keep a buffer for pre-payments and hence such loans where pre-payments are expected, cost the lenders more money to sell. The cost of such prospective secularization is one of the elements that go into pricing the loan to the consumer and hence if the pre-payment charge was not there to discourage pre-payment the loan would ab-initio be more expensive for all borrowers. Again internationally pre-payment charges are a norm.

Most forums whether they are regulators (RBI which regulates all banks) or courts or the Competition Commission of India, in various contexts have already allowed the practice of charging the pre-payment penalty. Only National Housing Bank (the regulator for housing finance companies such as HDFC Ltd., LIC Housing Finance Co. Ltd, etc.) has issued a circular dated October 18, 2010 requiring the housing finance companies not to charge borrowers any pre-payment charge if the pre-payment is “from their own sources.”  This sounds slightly ambiguous since they have not defined what constitutes “own sources” or how the proof will be provided.

“The own sources referred here should be illustrative in nature where funds coming from sources like salary arrears, bonuses, disposal of lands and selling of jewellery etc. are covered. If a customer is borrowing monies from relatives, friends and spouse or have shopped for the cheaper loan from some other lender then he is defeating the purpose” , says Mr. R. S. Garg, General Manager, Department of Regulation & Supervision, National Housing Bank.

So why does the issue of pre-payment charges get so much attention?

That is because it is inextricably linked to the issue of unfair floating rates that lenders charge to existing consumers as compared to what they themselves give to new consumers (Girl friend versus wife syndrome – see DNA dated February 7, 2009). When consumers are being charged an unfair interest rate, they naturally feel even more cheated when they have to pay a fee to shift to a lower rate (no matter how justified the charge is). Unfortunately the focus is on the wrong place.

The lenders erect a lot of what can only be called non-tariff barriers to shifting the loan to a new lender. The new lender needs a lot of cooperation from the existing lender in terms of giving certificates for the documents held by them as security and the amount due on the existing loan etc. The existing lenders for obvious reason are not very cooperative.

Now if only like TRAI, the concerned regulators (RBI and NHB) laid down the framework and rules by which loans can be ported from one lender to the other simply by sending a SMS to a short code. I am sure the consumers may not mind paying the portability charge (pre-payment charges) though it is considerably higher than Rs. 19/- charged for mobile number portability.