A Pre-payment charge or a Pre-payment penalty is a clause in a mortgage contract stating that if the mortgage is prepaid within a certain time period, the borrower will be charged a penalty by the lender. The penalty amount is usually a percent of the outstanding mortgage amount or 3 months of interest, which varies from bank to bank.
Why banks charge Pre-payment penalties?
When borrowers repay the outstanding sum all at one go, the bank lose out on the interest it would have earned from the borrower, had the borrower paid the EMI’s over a longer tenure. To compensate for this reduction in revenue, banks levy a Pre-payment penalty on the borrower.
Why do borrowers pay the outstanding loan amount before maturity?
The market interest rates fluctuate every now and then. Many borrowers who have opted for a fixed interest loan will want to refinance their loan, incase the interest rates fall. They usually transfer their loan to another bank offering a lesser rate of interest. The money is transferred from the new bank to the existing bank. The existing bank then levies a Pre-payment penalty on the borrower for the interest lost.
The RBI has banned the banks to levy any penalty on individual borrowers for Pre-paying floating loans. Now, some banks are phasing out of the Pre-payment penalty to attract customers.