Prepayment penalties: A boon for small firms?

A recent draft circular released by the Reserve Bank of India (RBI) proposes banning foreclosure or prepayment charges on loans to small firms and increasing transparency in disclosures.

- PRASANNA TANTRI

In this article, I argue that while enhancing transparency is welcome, banning prepayment penalties, though well-intentioned, may ultimately be counterproductive in improving access to credit.

Let us first understand the proposed provisions and the RBI's likely intentions. The draft circular states that "divergent practices" of lenders concerning foreclosure charges/prepayment penalties lead to "customer grievances and disputes." The RBI also appears concerned that lenders include clauses that prevent borrowers from switching to other lenders "either for availing lower rates of interest or better terms of service."

Thus, the RBI seems to believe that imposing prepayment charges allows banks to exercise power to the detriment of borrowers. Therefore, restricting such charges will likely benefit borrowers by increasing their choices.