RBI bars prepayment penalty on floating rate micro, small business loans - Finance Ppl

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RBI bars prepayment penalty on floating rate micro, small business loans

What is prepayment penalty?

Prepayment penalty also known as foreclosure charges is a levy on the borrower, charged to compensate lending institution for the interest income they lose when a borrower repays/settles the loan in full, before completion of Loan tenure.

What is the need for prepayment penalty?

Interest earned on loans and advances is the primary source of income for the lending financial institutions. Loans/credit facilities are structured in such a manner to generate a specific amount of interest over the loan's life. When a loan is paid off early, the lender lose out on that interest and affects their profitability. To Compensate for that loss/ offset that loss, some lenders charge a penalty for early repayment.

Further details on Prepayment penalty :

Prepayment penalties were associated with both fixed and floating rate loans. Were applicable to home loans and personal loans taken by Individuals and also to loans taken by corporates regardless of interest rate type, unless specifically waived in the loan agreement.
The levy can be either fixed percentage of outstanding loan balance at the time of prepayment or it can be determined based on the number of months remaining in the loan term or flat fee, regardless of remaining balance or term.

Over years, RBI had gradually phased out prepayment penalty on floating rate loans especially for individual borrowers, while Fixed rate loans generally continued to attract prepayment charges unless waived by the lender.

Why is this in news?

As mentioned above, even before the recent directive, several RBI circulars in the past had exempted many floating rate term loans and home loans taken by Individuals from prepayment penalties. The recent directive consolidates, formalises and brings all those circulars under one unified statutory framework called Reserve Bank of India (Pre-payment Charges on Loans) Directions, 2025. This directive bars levy of foreclosure charges/ pre-payment penalties on floating rate term loan taken by individual borrowers and MSEs.

Motive behind this directive:

In this regard, RBI highlighted the need to ensure availability of easy and affordable access to micro and small enterprises. It further noted that its supervisory reviews revealed inconsistent practices among lenders regarding pre-payment charges on loans to MSEs, which led to customer grievances and disputes.
Furthermore, certain financial institutions are found to include restrictive clauses in loan contracts/ agreements to deter borrowers from switching over to another lender, either for availing lower rates of interest or better terms of service.

Accordingly, in order to correct such practices and ensuring ease of business for customer, RBI issued the directives in exercise of powers conferred under Banking Regulation Act (Sec 21, 35A and 56)Sections RBI Act (Sec 45JA, 45L and 45M) and National Housing Bank Act (Sec 30A).

What's the new provision all about?

Here's the crisp summary of the Reserve Bank of India (Pre-payment Charges on Loans) Directions, 2025:

  1. The new norms will be applicable to all loans and advances sanctioned or renewed on or after January 1, 2026.
  2. Applicable to all commercial banks (excluding payment banks), co-operative banks, NBFCs, and All India Financial Institutions.
  3. Regulated entities (RE) shall not levy pre-payment charges on
    1. all floating rate loans and advances that are granted to individuals for non business purpose.
    2. floating rate loans and advances granted to individuals and MSEs for business purpose, subject to lender type and loan amount*.

      *Which means, with respect to floating loans granted for business purpose. while most REs are prohibited from charging PPC, Small Finance bank, Regional Rural bank, Tier 3 Primary (Urban) Co-operative bank, State Cooperative bank, Central Cooperative bank and an NBFC-Middle layer shall not levy any pre-payment charges on loans with sanctioned amount/ limit up to ₹50 lakh.

  4. An RE shall not levy any charges where pre-payment by the customer/borrower is initiated at the instance of the lender.
  5. Applies even to Dual/ special rate loans (ie combination of fixed and floating rate). Provided, the floating rate is active at the time of pre-payment.
  6. The directions shall apply irrespective of the source of funds used for pre-payment of loans, either in part or in full, without any restriction wrt lock in period ie(borrower can prepay their loans at any time)
  7. For all other loans such as:
    1. Fixed rate loans
    2. Loans to corporates or large exterprises
    3. loans from lenders that are not covered under specific exemptions,
    pre-payment charges shall be as per the approved policy of the regulated entity.
  8. The applicability of pre-payment charges shall be clearly disclosed in the sanction letter and loan agreement.
  9. The RE at the time of pre-payment of loans, shall not levy any charges retrospectively that were waived off earlier by the RE.
  10. In case of cash credit/ overdraft facilities, no pre-payment charges shall be applicable, if the borrower intimates the lender in advance of its intention not to renew the facility and the facility gets closed on the stipulated due date and not before/earlier.
  11. However in case of term loans, pre-payment charges if levied by the RE shall be based on the amount being prepaid. In case of cash credit/ overdraft facilities, pre-payment charges on closure of the facility before the due date shall be levied on an amount not exceeding the sanctioned limit.