Foreclosure 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 prepayment penalties for several reasons. When a loan is approved, the bank allocates funds for the agreed duration and may face difficulties redeploying these funds quickly. Prepayment can disrupt the bank's cash flow and profitability, as it may lose out on expected interest income. The penalty helps offset this potential loss. Additionally, penalties serve as a deterrent to prevent borrowers from switching to other banks.

For MSME borrowers, managing prepayment carefully is essential. Here’s how to approach the situation:

1. Prepayment Penalty Calculation: Ensure the penalty is calculated based on the outstanding loan balance, not the original loan amount. For instance, if you borrowed ₹10 crore and have ₹2 crore remaining, the penalty should apply to the ₹2 crore, not the full ₹10 crore.
2. Negotiate the Penalty Rate: Prepayment penalties can be as high as 4% of the total loan limit, which can be a significant deterrent when considering switching lenders. Negotiate this rate when accepting 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 using funds from another bank.
4. Penalty Waiver Conditions: If you plan to exit the banking relationship due to poor service or other reasons, negotiate that the penalty applies only if you terminate the relationship within a certain period (e.g., within one year).
5. Lock-In Period: If the lender insists on a longer lock-in period, propose that no penalty applies if you give advance notice before the renewal date. Ensure these agreements are documented in writing.
6. Working Capital Loans: Prepayment penalties should ideally apply only to term loans, not working capital loans, which are demand loans and repayable as needed. While banks may not always agree, negotiation and proper documentation could sometimes result in 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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