Whether Banks or NBFCs can levy foreclosure charges on Prepayment of loan?

Introduction

In the context of loans, especially home loans or personal loans, foreclosure charges or prepayment penalties refer to the fees charged by Banks or Non-Banking Financial Companies (NBFCs) if the borrower chooses to pay off the loan amount before the stipulated loan tenure.

Such pre-payments can be of two types: Part Prepayment and Absolute Prepayment (Foreclosure).

Banks and NBFCs are not allowed to demand foreclosure or prepayment charges on any term loan of floating rate of interests from individual borrowers. But they can levy such charges on term loans of fixed rate of interests from individual borrowers and any term loan taken by non-individuals which means businesses, partnership firms or body corporates.

What is a Floating Rate of Interest?

A floating rate of interest is an interest rate that adjusts periodically based on economic or financial conditions. Unlike fixed rates, floating rates are tied to a benchmark, such as a market index or reference rate. They provide flexibility as they can decrease or increase based on market trends, offering potential advantages depending on economic conditions.

What does RBI say in this regard?

Reserve Bank of India has from time to time advised the banks and NBFCs not to charge prepayment or foreclosure charges:

• Reserve Bank of India, vide its Circular bearing Ref. No. RBI/2013-14/582; DBOD.DIR.BC.No.110/ 13.03.00/2013-2014 dated May 7, 2014, states inter-alia that ‘banks will not be permitted to charge foreclosure charges/pre-payment penalties on all floating rate term loans sanctioned to “individual borrowers”, with immediate effect’.

• Guidelines dated July 14, 2014 relating to “Levy of foreclosure charges/pre-payment penalty on Floating Rate Loans” addressed to all NBFCs informing that the “NBFCs shall not charge foreclosure charges/pre- payment penalties on all floating rate term loans sanctioned to individual borrowers with immediate effect”.

• Reserve Bank of India vide circular dated August 2, 2019, clarified that ‘banks shall not charge 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)‘.

What about MSMEs?

Code of Bank’s Commitment to Micro and Small Enterprises dated August 2015 released by BANKING CODES AND STANDARDS BOARD OF INDIA which states: “Permit prepayment of fixed rate loans up to 50 lakh without levying any prepayment penalty” and “prepayment of floating rate loans without levying any prepayment penalty”.

Banking Codes and Standards Board of India (BCSBI)

BCSBI was an organization that safeguarded the rights of banking service consumers in India. The primary responsibility of this board was to ensure that banks comply with the “Code of Bank’s Commitment to Customers.” It’s important to note that BCSBI did not act as a compensation mechanism. Instead, it investigated individual complaints only to identify any systemic failures in compliance. As an independent and autonomous entity, BCSBI was registered as a separate society under the Societies Registration Act, 1860 on 18 February 2006.

During its initial years, the Reserve Bank of India provided financial assistance to the Board, covering its expenses for the first five years. However, on 28 September 2021, the member banks passed resolutions in favor of dissolving BCBSI. Consequently, the board has ceased its operations and is currently in the process of dissolution.

M/S Dynamix India Drill Con. Co vs HDFC Bank Ltd. on 10 July, 2023

The Ld. DJ, Rohini Courts, Delhi held on 10 JULY, 2023 that the plaintiff is an MSME hence it was not exempt from the foreclosure charges levied by Banks. The RBI has only prohibited the levying of foreclosure charges on the “individual borrowers” and MSMEs are not exempt under such guidelines. The Commercial Court held that the Bank is entitled to demand foreclosure charges from MSMEs.

Janak Shantilal Patel vs M/S Aditya Birla Finance Limited on 30 September, 2022

The Gujarat High Court held that since the loan was taken jointly by the partners of a partnership firm and was not taken in their individual capacity but as the partners of the firm because the property belonged to the partnership firm hence the defendant/NBFC was allowed to levy foreclosure charges on the loan, because the petitioners are not allowed to get the benefit as “individual borrowers”.

Is levying of prepayment charges considered an Unfair Trade Practice?

RBI vide its guidelines dated 25 November, 2008 did provide that loan application forms in respect of all categories of loans should include information about fees/charges, if any, payable inter alia for pre-payment options and any other matter which affects the interest of the borrower, so that a meaningful comparison with the terms and conditions offered by other banks can be made and an informed decision can be taken by the borrower. It also declared that levying such charges subsequently without disclosing the same is an unfair practice.

The Delhi High Court held in the case of DLF Ltd. v Punjab National Bank, 2011 SCC OnLine Del 2465 the violation of the aforementioned guidelines of RBI would be considered an Unfair Practice on the part of the Banks.