What are prepayment charges?

Levy of pre-payment charges is a normal practice adopted by the Housing Finance Institutions (HFIs) to primarily cover two types of costs which are as follows:

1) Banks/HFCs raise deposits/loans at a cost; so the funds come at a price. Banks/HFCs may not have the right to pre-pay these deposits/loans back to their depositors/lenders and hence, may continue to incur a cost. The pre-payment charge helps the HFIs in mitigating this cost.  

2) Apart from the cost of capital, there are several direct expenses occurring due to legal verification, technical verification, origination costs and other miscellaneous costs. Banks/HFCs recover such expenses from the borrower in the form of processing fees. Nowadays, out of increasing competition or excess liquidity with banks/HFCs, they offer heavy discount on the processing fees during their promotional campaigns.

3) HFIs require time to deploy the pre-paid amount afresh. Pre-payment charge is intended to compensate the HFIs for the loss of interest for the period these funds remain idle.

When to prepay?

As a thumb rule, (not applicable in all cases), however, it will normally make sense to prepay the home loan as long as the pre-payment charges do not exceed 2%. There are two big exceptions to this thumb rule:

1) Where the interest rate on the existing home loan is lower than the current ruling rates (for example, where you had entered into a fixed rate contract earlier when the rates were low). 2) If principal repayment of the home loan increases the amount of deduction under Section 80C of the Income Tax Act 1961 (this will happen if you are not fully utilizing the Rs. 1,00,000 limit of deduction under this Section through other modes of investment such as life insurance premiums, contribution to provident fund etc).

It is permissible for borrowers to save on prepayment charges by making partial pre-payments. Quite a few HFIs do not charge pre-payment penalty if the loan is prepaid partially. The definition of what constitutes partial pre-payment varies from HFI to HFI. You can make enough pre-payment to ensure that you still need to pay a few more EMIs (normally 12) to completely clear off the loan. This will ensure savings in pre-payment penalty and at the same time help you to save on high interest costs on a substantial portion of the loan. The rules in this regard, however, vary from HFI to HFI. It is therefore, advisable to understand the lending HFI's rules on the subject before concluding the loan transaction.

How to pre-pay?

Borrowers consider the option to pre-pay the housing loan in full under various circumstances such as:

1. A borrower has got surplus funds and he/she does not have a plan to invest it at a return higher than the rate of interest payable on the outstanding housing loan.
2. A borrower is nearing retirement and wants to close all loan liabilities before retirement.
3. A borrower wants to shift place of residence, say to another Country.
4. Borrowers also consider the option of pre-payment when current rates of interest on new housing loans are lower than the rate applicable on the loan taken by them. In such situation, some borrowers raise new housing loan and pre-close old loan with the proceeds of the new loan. While considering such option, it is, however, advisable to undertake proper cost-benefit analysis. The savings out of lower rate of interest on new loan should be more than the cost/outgo in the form of pre-payment charges payable on the old loan plus one time upfront charges payable on the new loan.