Make the most of the loan pre-payment penalty waiver, but ensure that you gain from the move

Home loan borrowers, especially those planning to prepay the loan, can breathe easy. The Reserve Bank of India has indicated it would scrap the prepayment penalties charged by banks. The National Housing Bank (NHB) has also sent a notification to housing finance companies on scrapping prepayment penalties on floating rate loans. Those who opted for fixed rate loans can also escape the penalty if they pay off the outstanding dues from their own savings.

DIKTAT ON PREPAYMENT

Earlier in September, the Banking Ombudsman had recommended the abolition of prepayment charges levied on floating rate home loans. It suggested that banks should rather address their asset liability mismatch even with fixed rate loans through interest rate swaps instead of passing on the cost to the borrower in the form of prepayment penalty. “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 prepayment penalties in the case of fixed rate loans,” the RBI said in a notification. The banking regulator, in its mid-year credit policy last week, again stated that it proposes to implement the recommendations of the Damodaran Committee, on which a broad consensus has emerged. The committee, set up by the RBI to suggest ways to improve services to bank customers, had suggested, among other things, that prepayment charges be removed.

Typically, banks and housing finance companies charge a prepayment penalty of 1.5% to 2% on the outstanding loan amount. Some banks and HFCs have started waiving the penalty if borrowers paid the dues from their own savings. However, banks charge a penalty if the borrower shifts to another lender to benefit from lower rates. The NHB, in its recent notification, said that HFCs should not charge the penalty on pre-closure of floating rate loans irrespective of the source of fund. If the housing loan is on a fixed rate basis, the loan should be preclosed by borrowers from their own savings.

IMPACT ON BORROWERS

“It is a very welcome customerfriendly step. It could not have come at a better time than this when customers are gasping for breath due to the high interest rates. Prepayment of any amount without penalty in case of floating rate loan is a great step,” says Suresh Sadagopan, certified financial planner and founder of Ladder 7 Financial Advisories. Over the past few months, most banking experts were talking about interest rates peaking out. The rates have, however, gone up by 1.5%.

The new norms will also give home loan borrowers servicing a floating rate loan the freedom to shift to lenders offering lower rates. “Existing borrowers were not willing to take the benefit of lower rate offered by other banks considering the net benefit after adjustment of pre-payment charges. But the scrapping of prepayment penalty will result in healthy competition. This will also restrain companies from hiking rates indiscriminately,” says Pankaj Mathpal, CFP and managing director of Optima Money Managers.

MAKING SENSE OF PREPAYMENT

“Ideally, prepaying at the beginning of the tenure of a loan is a better idea as the interest outgo will be maximum then. If there is a 20-year loan, prepaying it in the first five years will probably be the most beneficial,” says Sadagopan. “But, prepaying will probably not bring the interest below Rs. 1.5 lakh per annum (even if the person prepays . 5 lakh, the interest component will still hover around the Rs. 5 lakh figure),” he says.

Home loan borrowers can claim tax benefits on the interest paid under section 24 (a) of the I-T Act. If the property is self occupied, tax deduction of up to Rs. 1.5 lakh can be claimed in a financial year. But if the property is let out, the whole amount of interest paid can be set off against the rent received. “Considering the above, in case of let-out property, it is advisable to serve the loan for the full term and set it off against the rent. In case of self-occupied property, if the individual expects to earn higher return on his investment compared with the interest being paid on the home laon, he/ she should serve the loan to such an extent that the interest paid during the financial year is limited to Rs. 1.5 lakh,” says Mathpal.

SHORTER TENURE LOANS BETTER BET

Let us compare the borrower taking a 20-year loan and paying the EMI till the end of the 10th year and then prepaying the balance loan outstanding as a lumpsum. “Let us then compare this to a 10-year loan and paying it over 10 years. If that is the case, taking a 10-year loan would be better. A 10-year loan for Rs. 50 lakh, for example, at 11.5% per annum has an EMI of Rs. 70,297, compared with Rs. 53,321 for a 20-year loan. In any loan, the interest portion of the EMI is higher in the initial period. Due to this, the total amount paid to close in the 20-year loan in 10 years (the amount will be the total interest outgo in the first 10 years of a 20-year loan with an EMI of Rs. 53,321 and then the balance repaid as a lump sum) will be higher than the total interest outgo on a 10-year loan paid over 10 years with an EMI of Rs. 70,297,” says Rishi Nathany, certified financial planner and director, Touchstone Wealth Planners. This, in effect, means you will end up paying more on a 20-year loan of Rs. 50 lakh prepaid in 10 years than on a loan with anoriginal tenure of 10 years.

In short, if you are prepaying a floating rate home loan either with a bank or HFC you can save on prepayment charges even if you switch to a cheaper lender. However, you may have to pay processing fees and other charges depending upon the bank/ HFC’s policy. If you are a fixed rate home loan customer with a bank, you will still have to pay the prepayment penalty irrespective of the source of your funds. If you are a fixed rate loan customer of a HFC and prepay the outstanding dues out of your own savings, you don’t have to pay the penalty. However, switching lenders for fixed rate loan customers will attract a prepayment penalty.