What is a prepayment penalty on a personal loan and how does it affect you?

Personal loans are becoming increasingly popular in India as they are easily available and convenient. Prominent lending institutions such as: HDFC Bank, ICICI Bank, Kotak Bank, Bajaj Finance, CreditAccess Grameen among others are rapidly scaling up loan distribution services.

Due to the rapid distribution of loans we are also witnessing a rise in defaults, errors and difficulties in repayment across the entire financial sector. There are also several other important aspects that are missed by everyday borrowers.

Most of the borrowers do not think about one vital point: loan prepayment penalties. These charges are levied on borrowers when they wish to pay the loan back early, either partially or fully. In this article, we shall be covering the concept of prepayment penalties, what it means, and the recent changes in rules that affect Indian borrowers.

What is a prepayment penalty?

Prepayment penalty is a fee charged by lenders when the borrower repays his personal loan before the completion of its tenure. It is to compensate lenders for the interest rate they would have earned over the period of the loan. The charge varies between 1% and 5% of the outstanding amount, depending on the lender’s policy. Bajaj Finserv, for example, charges a prepayment of 4.72% plus applicable taxes.

Now every bank and financial institution has its own prepayment terms, conditions and rules. These rules are also open for changes from time to time. That is why it is prudent for you to reach out to your financial institution and clearly understand the prepayment charges, terms and conditions on an individual basis before applying for the same.

Recent developments: RBI guidelines

As part of a significant overhaul, the Reserve Bank of India (RBI) has proposed and the issue is in discussion phase currently to abolish foreclosure fees and prepayment charges on floating-rate loans extended to individual and micro and small business (MSE) borrowers. This is likely to encourage cautious lending habits as well as provide some financial relief to the borrowers.

It is notable that the guidelines are in the proposal stage currently, and the RBI invited comments from the stakeholders concerned by 21 March 2025 before the finalisation of the rules. Further details on this development are therefore to be expected.

How does it help the borrowers?

Prepayment fees would generally discourage the borrower from prepaying on personal loan according to their eligibility when they can make better financial decisions by paying the amount promptly.

Thankfully, now with RBI contemplating new regulations for the future, borrowers of floating-rate personal loans will enjoy the advantage of prepayment without any cost as well.

First of all, the borrowers must thoroughly read the fine print of the loan contract for prepayment cost conditions and make their decision accordingly.

Escaping prepayment charges

To escape such charges, the borrowers may opt for lenders that do not levy prepayment charges, such as IDFC First Bank that offers personal loans without any prepayment charge. Borrowers also need to see to it that they properly check their financial standing and compare the benefits of prepaid loans, especially if they would be saving interest without paying any charge.

Lastly, it is important to acknowledge and remember that taking a loan in itself is a risk. As loans or availing credit are debt instruments. They are offered to individuals with a promise of easy terms, repayment tenures, low interest rates etc.

Post the same once the loans are availed the real challenge begins with the repayment charges and management of finances thereafter. The reason for the same is that loan repayment generally happens at very high interest rates and it is extremely difficult to match up to the repayment terms and conditions.

Due to all these reasons it is always prudent to first carefully think through a loan and consult a certified financial adviser before applying for the same.

Disclaimer: Taking a loan involves financial risks, and prepayment may come with complications and additional charges. Please consult your financial institution for detailed terms and professional advice before proceeding.