Do you pay to prepay?

RBI imposes restrictions on imposition of prepayment charges on floating rate loans

– Anita Baid, finserv@vinodkothari.com

Following the announcement made in the Statement on Developmental and Regulatory Policies dated October 9, 2024, the RBI had released a draft circular inviting comments from stakeholders on its proposed guidelines regarding the levy of foreclosure charges and pre-payment penalties on loans.

Based on the comments received and supervisory findings, the final Reserve Bank of India (Pre-payment Charges on Loans) Directions, 2025 have been issued on July 2, 2025 (‘Prepayment Directions’).

Coverage

The Directions consolidate the diverse practices and provisions on levy of prepayment charges for all lenders. This would ensure uniformity with regard to prepayment of various loans by borrowers of banks and NBFCs (including HFCs).

Prepayment Vs. Foreclosure

Prepayment or foreclosure is the early repayment of a loan facility by the borrower, either in part or in full before the pre-fixed repayment schedule. However, the distinguishing factor is that pre-payment means early payment of scheduled installments, while foreclosure means early payment of the entire outstanding amount leading to early closure of the loan term. To an extent, pre-payment is usually partial in nature whereas foreclosure is the closure of the loan account before the due-date. However, given that prepayment can be both partial or full, it could be said to be a broader term that may also cover foreclosure or full prepayment.

So will there be a difference between foreclosure charges and prepayment charges? Conceptually, both have the same meaning. The only difference is in the terminology as the charges levied at the time of foreclosure are termed as foreclosure charges and charges levied at the time of pre-payment of an instalment are termed as pre-payment charges.

Given that the Prepayment Directions are referring to only prepayment charges unlike the draft circular, that had a mention about both foreclosure charges and prepayment penalties, this could enable lenders to create an arbitrage. However, it is important to note that RBI under para 5 (iii) states that prepayment penalty cannot be levied irrespective of the source of funds used for pre-payment of floating rate loans, either in part or in full. Hence, going by the intent of the regulator, the provisions should apply on both partial as well as full prepayment by the borrower and hence, covering both prepayment charges as well as foreclosure charges.

Fixed Vs Floating Rate of Interest

A fixed rate loan refers to interest rates that remain locked throughout the loan tenure, while a floating rate term loan refers to interest rates that are subject to fluctuation owing to certain factors. Lenders determine the floating rate on the basis of a certain reference rate. Usually, the floating rate is a spread over and above the base rate. Reference rate is determined by taking into account the cost of funds, credit cost,  liquidity cost, operating expenses, expected return on equity, etc. Lenders have the option to change the reference rate prospectively depending on changes in the input factors and hence, the changes can be passed on to the borrowers. Therefore, floating rate loans are expected to provide the flexibility to the individual and small-corporate borrowers to prepay at any point of time without incurring any additional charges.

In case of fixed rate loans, the levy of pre-payment charges, if any, should be based on the board- approved policy of the lender (Para 6 of Prepayment Directions). Here, the policy among other things must also ensure the following:

1. For term loans, pre-payment charges shall be based on the amount being prepaid.
2. For 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. Further, no pre-payment charges shall be applicable if the borrower intimates the lender of its intention not to renew the facility before the period as stipulated in the loan agreement and the facility gets closed on the due date.

As per the Prepayment Directions, applicability of Prepayment Directions in case of dual/ special rate (combination of fixed and floating rate) loans will depend on whether the loan is on floating rate at the time of pre-payment. Hence, in case at the time of exercising the option to prepay, the loan term is running at floating rate, the provisions of the Prepayment Directions shall become applicable.

Levy of Prepayment Charges

The levy of prepayment charges by the applicable lenders, including banks and NBFCs would be regulated by the Prepayment Directions. Under the erstwhile regulations, the prepayment charges were levied as follows:

1. NBFCs (other than HFCs), cannot levy foreclosure charges/ pre-payment penalties on any floating rate term loan sanctioned for purposes other than business to individual borrowers, with or without co obligant(s).
2. HFCs are not permitted to charge foreclosure charges/ pre-payment penalties in case of foreclosure of floating interest rate housing loans or housing loans on fixed interest rate basis which are pre-closed by the borrowers out of their own sources.
3. Banks are not permitted to charge foreclosure charges / pre-payment penalties on home loans / all floating rate term loans, for purposes other than business, sanctioned to individual borrowers.

Now under the Prepayment Directions, the bar on the levy of prepayment charges in case of certain floating rate loans to individuals has been extended to cover loans to Micro and Small Enterprises (MSEs) as defined in Micro, Small and Medium Enterprises Development (MSMED) Act, 2006. Accordingly, the following restrictions shall apply, irrespective of the source of funds used for pre-payment of loans, either in part or in full, and without any minimum lock-in period.:

1. Banks and NBFC-UL (including HFCs in Upper Layer, shall not levy prepayment charges for all floating rate loans granted for purposes other than business to individuals, with or without co-obligant(s) and all floating rate loans granted for business purpose to individuals and MSEs, with or without co-obligant(s). It is interesting to note that the earlier exemption on housing loans by banks on fixed interest rate basis which were pre-closed by the borrowers out of their own sources seems to have been removed.
2. NBFC-ML (including HFCs) shall not levy prepayment charges for all floating rate loans granted for purposes other than business to individuals, with or without co-obligant(s) and all floating rate loans granted for business purpose to individuals and MSEs, with or without co-obligant(s), with sanctioned amount/ limit up to ₹50 lakh
3. NBFC-BL shall not levy prepayment charges for all floating rate loans granted for purposes other than business to individuals, with or without co-obligant(s)
4. Additionally, HFCs cannot levy prepayment charges on housing loans on fixed interest rate basis which are pre-closed by the borrowers out of their own sources. Refer para 85.6 of the HFC Master Directions.

Further, pre-payment charges cannot be levied in case the prepayment is effected at the instance of the lender (for e.g., where the lender requires the borrower to either accept revised rates of interest, or prepay the facility).

To understand the restrictions, the following approach may be applied by the lenders:

1. Are loans extended on Floating Rate or Fixed Rate?
2. In case of Floating Rate Loans, are the loans given to individuals or MSEs?
3. In case of loans to individuals, is the end use for business purpose or personal purpose (including housing loans)?
4. In case of loans to MSEs, is the sanctioned amount less than ₹50 lacs?

Based on the response to the aforesaid question, the various permutations and combinations that can be arrived at, has been demonstrated below:

Disclosure to Borrower

The applicability pre-payment charges are required to be clearly disclosed in the KFS, sanction letter and loan agreement. It is important to note that failure to disclose may abstain the lender from levying any pre-payment charges.

Snapshot of the levy of prepayment charges

Levy for Prepayment Charges
Type of Loan	Type of Interest	End Use/ Sanctioned Amount	NBFC-BL	NBFC-ML (other than HFCs)	NBFC-UL (other than HFCs)	HFCs	Banks (excluding payment banks)
Loans to Individuals	Fixed Rate	For Personal Use	Can be levied	Can be levied	Can be levied	Can be levied (except for housing loans foreclosed with own sources)	Can be levied
		For Business Use	Can be levied	Can be levied	Can be levied	Can be levied	Can be levied
	Floating Rate	For Personal Use	Cannot be levied	Cannot be levied	Cannot be levied	Cannot be levied	Cannot be levied
		≤ ₹50 lacs sanctioned for Business Use	Can be levied	Cannot be levied	Cannot be levied	Cannot be levied	Cannot be levied
		> ₹50 lacs sanctioned for Business Use	Can be levied	Can be levied	Cannot be levied	Can be levied (except for HFCs in Upper Layer)	Cannot be levied
Loans to Micro Small Entities	Fixed Rate	Any quantum	Can be levied	Can be levied	Can be levied	Can be levied	Can be levied
	Floating Rate	≤ ₹50 lacs sanctioned	Can be levied	Cannot be levied	Cannot be levied	Cannot be levied	Cannot be levied
		> ₹50 lacs sanctioned	Can be levied	Can be levied	Cannot be levied	Can be levied (except for HFCs in Upper Layer)	Cannot be levied
Loans to non-MSEs	Fixed	Any quantum	Can be levied	Can be levied	Can be levied	Can be levied	Can be levied
	Floating	Any quantum	Can be levied	Can be levied	Can be levied	Can be levied	Can be levied

Note that in cases where pre-payment charges can be levied, the same has to be as per the internal board approved policy.

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