Too much freedom to individual banks?

Too much freedom to individual banks?

Since banks have the freedom to levy foreclosure on fixed rate loans, some banks offer loans only on fixed rates.

In the recent past, bank borrowers were lured by advertisements offering low fixed rate of interest on loans for periods as high as 20 years.

While customers can opt for fixed or floating rates for home loans, several new generation banks now offer only fixed rates for car loans, personal loans, gold and other loans meant for individuals.

Apart from the rate per se, an individual should know the difference between a fixed rate and floating rate loan system in banks to take informed decisions while availing loans.

By definition, a fixed rate loan implies the interest rate is fixed during the tenure of the loan (sometimes, fixed rates on long term loans are reset at regular intervals, say once in 5 years). Like interest on fixed deposits, the subsequent changes in the interest rate structure may not affect the pricing of these loans.

On the other hand, floating rates “floats” with the market and get adjusted with the changes in the base rates of individual banks.  Generally, in the present economic scenario where interest rates are expected to fall, it is desirable to opt for floating rate loans.

Regulations: One has to understand why the banks, especially new gen banks, pushes the customers to avail fixed rate loans or even offer many loan products to individuals only on fixed rates.

In June, 2012, RBI directed banks not to levy foreclosure charges/prepayment penalties on home loans on floating interest rate basis. Similarly, from May 2014, in the interest of the consumers, banks are not permitted to charge foreclosure/ pre-payment penalties on all floating rate term loans sanctioned to individual borrowers.

Thus, these directions do not withdraw the freedom of banks in levying foreclosure/prepayments’ penalties on fixed rate loans.

Practices: Since the freedom to levy foreclosure/prepayment charges is available to banks on fixed rate loans, some banks offer loans to individuals only on fixed rates.

At the time of availing a loan, an individual cannot predict his future income during the loan period. These banks expect the loan to be repaid only on the terms stipulated at the time of sanction and deviations, if any, are charged heavily.

It is true that bank incurs a lot of expenses, especially manpower, in pitching the loan products and the processing fees levied may not be sufficient to recover these expenses. Banks expect to earn interest on these loans and for that purpose loans have to continue in the books.

One should know how this freedom is put in practice to the advantage of the banks and, certainly at the cost of innocent borrowers. Practices differ from bank to bank. Banks are expected to charge interest on the daily outstanding balances.

Stipulating a specific date for paying the EMIs and not apportioning the repayments received prior to these dates’ results in interest loss to the borrowers.

Surplus funds
A borrower may have surplus funds with him and bank will not permit him to repay the installments in advance; nor will the bank accept lump sum repayment.

Sometimes, additional interest is charged on the prepayments. Some banks also restrict the number of prepayments during the tenure of the loan.

In the case of gold loans where bullet payments are stipulated, part payments/foreclosure is permitted only after expiry of specific period from the date of loan availment.

Therefore, the borrowers are compelled to park their surplus funds in their savings account earning much lesser interest than they pay on the amount they borrow. At the same time, any delay in repayment is charged heavily by the banks.

Look at the practices for foreclosure! Not permitting the foreclosure during initial stipulated period (say 6 months), charging heavy amount computed as a percentage on the principal amount outstanding (higher the loan period remaining, higher is the rate), levying the interest for the remaining period, stipulating a minimum amount etc cost the borrowers  very heavily.

For home loans, switch from floating to fixed or fixed to floating is permitted at a charge computed as a percentage on the amount outstanding, subject to a minimum absolute amount.

An individual borrower should understand that availing a loan at fixed rates restricts his freedom of servicing the loans and any deviations from the repayment schedule will add to his cost.

A prudent borrower should not be guided by the rate alone. He has to keep the freedom of prepayment/ foreclosure (without loss) with him. And, certainly, he has to prefer floating rates to fixed rates.

In a country like India, RBI has to consider the interest of innocent consumers. RBI has to balance the consumer protection with the freedom to individual banks and consider issuing regulatory guidelines on levy of prepayment/ foreclosure penalties on fixed rate loans also, directs banks to provide both fixed and floating rates on loan products to individuals.

Too much freedom to individual banks in levying charges results in exploitation of ill-informed consumers.

One can hope for some action from RBI in this direction in the days to come.
(The writer is a retired public sector bank executive)