Pre-Payment of Loans

 

When a borrower secures funds from banks or financial institutions to meet business needs, the loan is typically repaid over a set period. However, there are times when the borrower has excess funds and wants to repay the loan earlier than planned, a process known as "Prepayment of Loans."

While prepayment may seem straightforward and beneficial, it comes with its own set of challenges. A key issue is that banks often charge a prepayment penalty, even though the borrower is clearing the loan early. This might seem counterintuitive, as you are paying off the loan rather than defaulting.

Banks impose these penalties for several reasons. When a loan is sanctioned, the bank allocates specific funds for the agreed term and may not be able to redeploy these funds immediately. Prepayment can disrupt their cash flow and profitability, as they may lose out on expected interest income. The penalty helps compensate for this potential loss. Additionally, penalties can act as a deterrent to prevent borrowers from shifting to another bank.

For MSME borrowers, it is crucial to plan and handle prepayment carefully. Here’s how to approach this situation:

1. Prepayment Penalty Calculation: Ensure that the prepayment penalty is applicable only on the outstanding loan amount, not the original sanctioned amount. For example, if you borrowed ₹10 crore and the outstanding balance is ₹2 crore, the penalty should be based on ₹2 crore, not ₹10 crore.
2. Negotiate the Penalty Rate: Penalties can be as high as 4% of the total limit, which can be a significant deterrent if you consider changing lenders. Negotiate this rate during the acceptance of the sanction letter.
3. Surplus Fund Repayment: Ensure that the penalty is waived if you are repaying the loan with your own surplus funds, rather than funds from another bank.
4. Penalty Waiver Conditions: If you intend to exit the banking relationship due to poor service or other reasons, negotiate to have the prepayment penalty applied only if you terminate the relationship within a specific timeframe (e.g., one year).
5. Lock-In Period: If the lender insists on a longer lock-in period, propose that no prepayment penalty should apply if you notify them well in advance before the renewal due date. Document these agreements in writing.
6. Working Capital Loans: Ideally, prepayment penalties should apply only to term loans and not to working capital loans, which are demand loans and repayable as required. Though banks may not agree to this, negotiation and proper documentation can sometimes lead to a waiver of penalties on working capital loans.

All negotiations and agreements should be made at the time of onboarding or accepting the sanction letter. Ensure that all terms are documented in writing. For further assistance, feel free to contact us at BankKeeping.

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