No More Prepayment Penalties for All Floating Rate Loans : RBI

14 comments Written on May 7th, 2014 by
Categories: Loans, RBI

At Capital Mind I have been strongly in favour of abolishing any sort of prepayment penalty. (Read: The Unnecessary Prepayment Penalty, written in 2011) The RBI had, in 2012, banned prepayment penalties on home loans.

Now, they’ve banned it on all sorts of floating rate loans. This will include any loans that you take for a fixed term, but at a floating rate. But this applies only to individuals (not corporates or trusts).

This is good for floating rate term borrowers of, for instance, education loans. They can now prepay without a penalty. Or for any other such loan.

The idea is that having a prepayment penalty restricts customers from shifting to cheaper funding opportunities; banks, though, have little risk because if their rates were to go up, the loan itself would pay more because it is a floating rate loan.

The restriction therefore reduces “discovery”. Without a prepayment penalty, the market will be incentivized to find the cheapest lender, so that everyone will fight to go to that rate - and therefore banks will “transmit” appropriate interest rates to customers.

Note: Most car loans are fixed term, fixed rate. Term loans of the “personal loan” variety too are fixed. These won’t benefit.

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

14 comments “No More Prepayment Penalties for All Floating Rate Loans : RBI”

Deepak,

Does this apply to home loans that are part fixed and part-floating? I have such a loan product and it’ll soon move to the floating window. I made a partial pre-payment and wasn’t charged any additional fee for it.

Just thought to clarify. Thanks in advance.

Cheers,
G

Typically they don’t charge now, most banks have removed such charges altogether.

I m not in favor of banks. but
1. No prepayment penalty
2. No penalty for low account balance
3. Cross ATM usage at bank’s cost
4. Free Cheques
5. Free Transfers
6. 4% interest and more in some banks….
7.Crores and crores of loans to Kingfisher and other dubious companies…

( western banks are completely different)

Not sure if this interference is a good idea. Banks will probably increase switching costs some other way. Higher processing fees perhaps. Which will end up hurting everyone and not just those who wish to switch.

A better way would be to have genuine competition in banking and prevent collusion. Other methods will probably cause more distortions and harm than good.

True, though they are doing the new bank thing tooooo slowly.

Fee restrictions are on the ball, I think. If you take depositor’s money, and you have an RBI backstop, then the regulations are legit which they impose to ensure banking is fair. I know it sounds like too much interference but it exists everywhere, even in the US (some states totally disallow with-recourse home loans for instance).

Great to see this point here. I’ve always wondered why the regulator needs to issue diktats on micro-banking issues – this fee, that fee, etc. Seems like there are better things, larger issues for the regulator to focus on. I’ve made this same point previously on the ban on MF entry loads which was a similar issue.

While it might be doing good (there’s no doubt about this), it would be a lot better if we had a healthy, competitive market which produced these outcomes via competition.

Furthermore, I think the regulator should address this issue more holistically. For example, it could have instead issued diktats on transparency (for example, on every loan, bank should provide a list of all fees, penalties on the front page and there should be nothing left out). Because the real issue here isn’t that the penalty is bad, but that the customer usually doesn’t know about it, or care to know about it until the moment comes for them to prepay.

So, the issue should be addressed by making sure that the customer knows about it (and any other fees into which this fee might shift into) with minimal effort, and if the customer still prefers to be ignorant, I don’t think the regulator should take the responsibility for doing good on behalf of the customer. There is this infantilization and mollycoddling culture among the govt and regulators which does more harm than good. There a few good things they do like this one, but then they do a lot more harm by holding back changes that they think the customer will have trouble adapting to.

And, if I remember right, when MF entry loads were banned, the expense ratios of funds shot up to the limit of 2.5% overnight. One could expect something similar here.

Not really – funds did increase their ratios but typically large funds went up about 0.25% or whereabouts. Net net, it was still substantially positive. And then SEBI created the “direct” option where management costs were much much lower.

Oh goodie, another argument. I don’t remember all the facts, but the funds responded not just with an expense ratio hike but also by introducing exit loads which weren’t there previously and by some other things like hiking trail commissions etc. I don’t remember the exact details so can’t give a proper response. Furthermore, in 2012, I think the max expense ratio was hiked. I don’t remember if it actually went through. But, there was plenty of angst about this:

http://www.fundsindia.com/blog/mutual-funds/impact-of-proposed-expense-ratio-hike/218

Anyway, isn’t an expense ratio hike of 0.25% worse than a 1% entry load if I invest for longer than 4 years in a fund. So, I don’t think its obvious if it was net net positive.

By the way, I don’t have a desire for entry loads! But, I don’t want high expense ratios either and I don’t want diktats either. The entire issue of SEBI involvement in dictating how much expense ratio should be and how much load should be is a never-ending, resource consuming exercise. They will keep fiddling with it for years and years. I’d rather have them issue a transparency guideline on all types of fees and be done with the issue forever (and the market should respond with diverse fee structures). And, SEBI should instead devote the time and resources on tracking down stock market fraud.

Exit loads were introduced, I agree, and then there was a regulation on how much exit loads could be. Trail commissions didn’t go up or didn’t go up much, and I only know because I am an AMFI registered distributor (I don’t do any business with it though) and I get the commission sheets from all the funds. Some funds did do a temporary increase (as in high first year trails etc) but that has died.

Max expense ratio has only been hiked for non-big-city penetration. To compensate we have much lower ratios for direct funds which have now taken the lions share of debt funds.

I think each regulation should be considered on merit. When there were hajaar funds, and there were no restrictions on funds, they didn’t create a zero entry load fund (other than ETFs). That means self regulation simply didn’t work, which is why SEBI stepped in. Then when the situation on fees went nuts, they forced the direct plan (which is good for funds, not for distributors) And then, they provided for extra fees for expansion. I believe what they did was good, but they could have done more; for instance, they should allow commissions to be given back to investors in any form. I also believe that funds should be allowed to do short-selling, and options and all that. I believe that some of these products should be allowed to be sold to “sophisticated” investors etc. But in the realm of regulation, there are stuff that makes sense and stuff that doesnt, and it’s nuanced – it’s not okay, in my book, to say that the regulator shouldn’t get involved at all, because in the case of system wide abuse, they definitely should…

SEBI needs to spend on market fraud anyway and they have enough money to do that and more. They don’t do it, for different reasons, I guess.

DJ – I didn’t agree with you on the entry loads I think. I believe that is good regulation in the face of abuse. I believe that the RBI move is also a good one in the face of abuse as well, to remove such prepayment penalties. But I also agree with you that a good way to do this is to increase competition. However, even with a lot of competition, it is quite likely that parties collude with each other to keep entry fees high. It might change if bank licenses are on tap, but you can bet that as an entity that can create money, a bank will remain highly regulated.

There are already diktats on transparency. Every bank has to make fees visible to all. They all have large PDFs with fees. How many of us bother to read them? Information assymetry comes from having way too much information that must be mandatorily disclosed, so when I go searching I get hit with a deluge of info and can’t easily find what applies to me. Solving this with a “buyer beware” clause is simply not right.

I agree that the infantilization and mollycoddling is a mess. And that they do more harm by holding things back. But this regulation, which is only for individual borrowers is addressing the info-arbitrage problem and of misselling (hiding costs), and eventually of increasing transmission of monetary policy. But there will still be penalties and fees for businesses, even for floating rate loans. (I think that should be taken out too, but I’m sure it is negotiated by borrowers)

Well, the diktats on transparency could be a lot better. The info could be mandated to be in the purchase/redemption receipt as well as the purchase screens of online brokers, etc (the exit load is indicated today when i redeem on ICICI Direct, they just need to add the same for expense ratio, trail commissions, etc at the time of purchase).

There is no doubt in my mind that these simple transparency steps would suffice. And, I often look for expenses in paper statements, email purchase, redemption receipts and don’t find them. Putting it there would be a huge step forward from having it in the SID/SAI.

You yourself say that it is an info-arbitrage problem and one of hiding costs. So, the solution should be to fix the arbitrage and un-hide the costs. The solution to an info-arbitrage issue is not to own the decision of what cost is reasonable. That is always best left to the market.

Oh I didn’t say the regulator should do nothing. I don’t want entry loads or prepayment penalties either! But, as you said it is an “info arbitrage and mis-selling (hiding costs)” problem. So, the solution should be to fix that and un-hide the costs, and not to sit and decide which number for one particular cost is reasonable (its like playing whack-a-mole). And, large pdfs aren’t enough, but adding the information in purchase/redemption receipts, online brokerage purchase screens ought to do it. Or, ask AMCs to send 2 page expense reports outlining all expenses of each fund to every investor quarterly or annually.

If that isn’t enough to bridge the info arbitrage gap, they should run TV ads saying entry loads/prepayment penalties are the work of the devil. Please tell your fund/banker to stop it. That would still be way better – those financial literacy funds have to be put to work.

Yeah, there is the thing with industry collusion. I don’t know what the best way to tackle that is. Maybe, making the entry barrier be somewhat more democratic for fund managers, so we have more participants rather than just the big AMCs, which is probably a good idea anyway? But, then we will have to worry about fund reliability. Wait, isn’t that what SEBI should actually be doing? Hmm.. maybe they prefer a small number of big participants and control over arbitrary decisions. Makes their job easier. In other words, I don’t know if SEBI prefers collusion, almost promotes it with diktats and otherwise, when it should be focused on preventing it.

I think a previous comment got lost (which is probably a good thing – the site must have decided I’ve hijacked this comment thread enough. Sorry lohit :P).

Sorry man – new spam checker is screwing up big time! Now approved. Also did the earlier post. Will remove if you want me to :)

You make some excellent points. I think there has to be a better solution, like you say; some of these decisions are a little too micromanaging. It’s a shame that we don’t learn any other way. Having said that a fund manager told me on twitter that there is no way SEBI will allow a “short selling” fund, which I think would be great to have as a portfolio hedge. But they won’t let it happen.