RBI proposes relief from foreclosure charges on floating-rate loans; how would this impact borrowers, lenders

The Reserve Bank of India (RBI) has proposed a policy change aimed at providing significant relief to borrowers by recommending the removal of foreclosure charges on floating-rate loans taken by individuals for non-business purposes. The proposal was mentioned in a draft circular titled 'Responsible Lending Conduct – Levy of Foreclosure Charges/ Pre-payment Penalties on Loans’.

This proposal also extends to micro and small enterprises (MSEs) with business loans up to Rs 7.5 crore, allowing them the option to prepay or foreclose loans without facing penalties. Further, there should be no minimum lock-in period for the foreclosure of floating-rate loans.

The draft proposal is intended for all Scheduled Commercial Banks (except Payments Banks), Local Area Banks, Co-operative Banks, Non-Banking Financial Companies (NBFCs), Housing Finance Companies (HFCs), and All India Financial Institutions (AIFIs).

However, the proposal does not apply to Tier-I and Tier-II urban cooperative banks or base-layer non-banking financial companies (NBFCs). The RBI has invited feedback from stakeholders until March 21, before finalising these guidelines.

Floating rate loans

Floating-rate loans have interest rates that vary according to market conditions, in contrast to fixed-rate loans where the interest rate stays constant. The fluctuation in floating rates is determined by external benchmarks such as the RBI’s repo rate or market-determined rates like the MCLR (Marginal Cost of Funds-Based Lending Rate).

Borrowers opt for floating-rate loans in anticipation of a decrease in interest rates, which could result in lower repayment obligations. However, these loans also come with the downside of potential increases in interest costs if rates go up.

Impact of this provision

The proposed modifications are intended to offer increased flexibility and transparency to individuals with adjustable rate loans, simplifying the process of loan repayment and minimising penalties. The initiative by the RBI is anticipated to streamline the borrowing experience for individuals in this specific category, ultimately improving the overall business environment.

However, the removal of foreclosure charges on floating-rate loans could significantly impact the earnings of banks and NBFCs, which currently rely on such fees as a revenue source. 

Larger banks, such as HDFC Bank, ICICI Bank, and Kotak Mahindra Bank, are expected to be less affected by this policy change, as they already do not impose prepayment penalties on loans to MSEs. This policy could lead to increased competition among lenders, as borrowers might be encouraged to refinance their loans with institutions offering more favourable interest rates.

How floating rate loans differ from fixed rate loans

With a fixed interest rate, the interest on your loan remains constant throughout the tenure, resulting in consistent EMIs and simplified budgeting. Opting for a fixed rate provides stability, shielding you from market fluctuations.

Fixed rates typically range from 1.5% to 2% higher than floating rates. Despite potential market rate reductions, your EMI will not adjust, potentially resulting in higher overall payments.

Conversely, a floating interest rate is subject to change according to market conditions and regulatory policies, tied to benchmarks such as the RBI’s repo rate or MCLR.

In the event of decreasing interest rates, your EMI decreases, allowing for potential savings. However, an increase in interest rates will lead to higher EMIs. While floating rates can be adjusted at the lender's discretion, fixed rates remain constant throughout the loan term.

Floating rates offer more cost-effective options compared to fixed rates but carry the risk of fluctuating payments.