To make an informed borrowing decision, it is essential for a borrower to understand the fees and charges associated with the loan thoroughly. Pre-payment of borrowings help in reducing financial burden and improves the credit score of the borrower. Also, when banks are struggling to do recoveries from the defaulters, should a genuine borrower be welcomed at the time of prepayment of loan ahead of time? It is an ordinary question in the minds of the borrower when they are suddenly summoned a foreclosure charge statement. Also, when lending is a commercial contract, whether repayment is done from one’s own sources or through a “takeover” by another bank should be irrelevant.

However, bankers have a different view. A detailed overview of foreclosure charges is provided in this article to make the borrower aware about the trade practice followed by banks at the time of closure or exit.

What is Foreclosure or Prepayment?

  • Prepayment is the early repayment of a loan by a borrower, in part or in full, often as a result of optional refinancing to take advantage of lower interest rates. In other words when a borrower entity pays off its loan entirely or in part before the defined due date, it is termed as prepayment.
  • Foreclosure or prepayment can be done from own funds of the borrower, or it can be in the nature of takeover of loan facility by another bank.

What are Foreclosure Charges or Prepayment Penalty?

Foreclosure or prepayment charges are charges on the principal value which the borrowing entity is going to prepay or shift to another bank under a balance takeover.

Limit-Based Facilities

Cash Credit / Overdraft / Packing Credit / Letter of Credit / Bank Guarantee

Foreclosure charges are levied on the full disbursed limit irrespective of the actual outstanding amount.

Example: If a borrowing entity has a Cash Credit limit of ₹100 Lakh with a bank, however outstanding amount is ₹50 Lakh, then foreclosure charges will be applied on ₹100 Lakh, though at the time of closure the outstanding amount payable is ₹50 Lakh only.

Instalment-Based Facilities

Term Loans / Machinery Loans / Vehicle Loans

Foreclosure is applicable strictly on the amount outstanding at the time of foreclosure of the loan.

Example: If a firm has taken a machinery term loan of ₹100 Lakh for 5 years tenor and at the end of 3 years the principal outstanding is ₹40 Lakh, then foreclosure will be applicable on ₹40 Lakh only.

How Many Percentages?

  • Generally, in case of MSME secured finance, the foreclosure remains in the range of 2% to 4%.
  • In case of individual loans or unsecured loans from NBFCs, the foreclosure may go up to 5% to 6%.

Where is it Provided in the Document?

  • Foreclosure charges are compulsory to be mentioned in either the sanction letter of the loan facility or the loan agreement.
  • In many cases, the loan sanction letters are silent on pre-closure charges. The loan agreements, which are always standard format of contracts thrust on customers, invariably have the specific covenants detailing prepayment penalty clauses and conditions applicable upon exit or balance transfer.

Author may be reached at: ca.nitin7989@gmail.com and eboard@icai.in