RBI’s New Pre-Payment Directions: Navigating The Tradeoffs Between Borrower Flexibility And Lender Viability

 [ Yarabham Akshit Reddy and Vaibhav Mishra are 4th Year Law Students at Hidayatullah National Law University, Raipur]

Introduction

Imagine a scenario where, as a borrower, you make every possible effort to repay your loan ahead of schedule. However, upon successful completion of pre-payment, you are unexpectedly confronted with a hidden cost – ‘prepayment charges’. The prepayment charges, typically levied by credit institutions to compensate their loss of anticipated interest income, often place a disproportionate burden on individuals and small businesses. For many, such charges act as a deterrent to early repayment or refinancing, even when more favorable credit terms are available elsewhere. In response to these longstanding concerns, the Reserve Bank of India (‘RBI’) has released the  RBI (Pre-payment Charges on Loans) Directions, 2025 (‘Directions’), which prohibit all the Regulated Entities from levying prepayment charges [‘PP charges’] on certain categories of loans, effective from 1 January 2026. The Directions aim to enhance borrower flexibility, promote fair lending practices and prevent restrictive clauses from deterring borrowers from switching lenders for better deals. However, while the Directions aims to build a borrower-friendly credit ecosystem, it raises several concerns about lender sustainability, cost recovery and unintended market consequences. Through this post, the authors examine these new Directions and their broader implications for borrowers, lenders, particularly in light of concerns surrounding the anti-competitive effects of such charges. Finally, it concludes with some possible recommendations to ensure targeted regulation of PP charges.

An Overview of RBI’s Restrictions On PP Charges:

The RBI has laid down the Directions that restrict banks from levying PP charges. The Directions divide loans into fixed rate and floating  rate loans. In case of floating rate loans given to individuals for non  business purposes, there is a complete ban on PP charges irrespective of the source of funds or timing of payment. For business loans extended to MSEs and small borrowers, certain categories of entities like upper layer NBFCs, central co-operative banks, all commercial banks with some exclusions, etc., are barred from levying any PP charges. In contrast, fixed rate loans are treated differently, where such charges could only be levied only in accordance with board-approved policy adopted by the financing institution. Further, the Directions mandate disclosure of PP charges in loan agreements, sanction letters, wherever applicable. The mandate for such disclosures surely increases trust in the lending ecosystem and protects borrowers from any unknown PP charges. The RBI’s decision to completely prohibit PP charges in floating rate loans is based on practical economic considerations of ensuring borrowers’ protection. In floating rate loans, unlike fixed rate loan, interest rates keep fluctuating based on various factors like source of funds, liquidity cost, etc. The inherent nature of floating rate loans provides flexibility to lenders to adjust interest rates over time in response to the changing input costs, such as credit risk and liquidity, to recover economic losses without such penalties. Since floating rate borrowers inherently bear the risk of fluctuating interest rates, they deserve the flexibility to prepay when it is financially advantageous. Imposing PP charges in such cases undermines this flexibility to switch lenders, which justifies the RBI’s decision to impose the ban.

RBI's direction & its role in addressing anti-competitive concerns of prepayment charges

The Directions could positively address the concerns surrounding a potential anti-competitive effect of prepayment charges on the market dynamics. The anti-competitive concerns on PP charges stem from the fact that the levying of PP charges by banks leads to a restriction of competition in the market, where such restrictive clauses deter borrowers from switching to lenders who offer better loan terms. The Competition Commission of India (CCI) in Sbri Surinder Bhakoo v. HDFC Bank also has acknowledged such similar concerns, observing that levying of prepayment charges “kills the competition in the market”. In the instant case, CCI held levying of pre-payment charges as an anti-competitive practice under Section 3 of the Competition Act, 2002 (Act). Moreover, the imposition of  PP charges could also potentially lead to an anti-competitive effect under Section 4 of the Act. This is because individual borrowers and small businesses are already in a weaker position as compared to the lenders due to various factors like information asymmetry, less bargaining power, access to resources, etc. This dynamic places the bank in a dominant position, creating a chance of probable abuse of its dominance.

Further, a reference should be made to a newsletter released by the Federal Trade Commission, Taiwan, which has also highlighted the anti-competitive nature of PP charges. It was observed that levying PP charges becomes a barrier to opting for better loan offers from other institutions. Also, a European Union study on retail banking found that prepayment charges operate as a ‘switching cost’ for consumers, deterring them from changing banks. It also found that PP charges/switching costs could operate as a tool for banks to discriminate between new & old customers. For instance, to attract new customers, bank would lower their charges, and once they are bound by agreement, banks could increase the prepayment charges, thereby reducing consumer choices. Thus, the study observed that such charges result in reduced market competition, ultimately leading to consumer harm. In light of the above analysis, the Directions would surely be expected to increase competition in the market, where borrowers have the freedom to opt for better deals, leading to competitive interest rates and better services. Consequently, the new framework would facilitate the healthy functioning of the lending market in the country.

Reform or Risk?: A Critical Analysis of RBI’s Directions on PP Charges

A.   Effect on Borrowers & Allied Concerns

The move by the RBI could have several positive implications from the perspective of borrowers and the market. Firstly, the Directions would facilitate affordable financing to micro and small enterprises (‘MSEs’). MSEs usually rely on this credit for their business cycle. In capital -intensive sectors like manufacturing and the service sector, this framework could be of great relief as they would now be able to refinance their loans without facing any unexpected financial burden created due to PP charges.  

Secondly, earlier, due to weak bargaining power with the borrower, lenders inculcated restrictive clauses in their loan agreements; however, in the post-directions scenario, the borrowers might witness a flip in lending practices. In cases where they are getting better credit opportunities with much lower interest than their existing lender, they could easily switch by repaying the loan without any additional costs.

Thirdly, the Directions could also lead to a beneficial effect on the economy. The very nature of the pre-payment charge deters a borrower from early repayment of the loan. Even if the borrower succeeds in prepaying his loan, he is faced with a PP charge, which reduces cash availability with the borrowers. Thus, by prohibiting PP charges, it benefits the economy by increasing cash availability & consequential spending in the market.

Despite these benefits, Directions come with certain pitfalls and concerns. For instance, it states that a blanket ban on PP charges is applicable irrespective of ‘source of funds used for pre-payment’ (P 5(iii)). However, this could potentially create problems relating to a lack of transparency & accountability on the part of borrowers. In a transaction where the source of funds for pre payment is neglected, it may raise concerns around the legitimacy of such repayments. This could have serious implications, as it may become a channel for illegal money to enter the formal financial system, as prepayments would provide it legitimacy. Thus, according to the authors, RBI should mandate full disclosure of the source of funds used for prepayments to maintain legitimacy & transparency in the financial system. Also, in adopting a pro-borrower stance, the RBI has ignored the interest of lenders, which could have negative implications. These concerns will be discussed in the forthcoming part.

B.    Impact of the PP Charges Ban on Lenders’ interest

The new pro-borrower framework created by the Directions has serious implications for lenders’ interests. Banning PP charges, without doubt, allows borrowers the freedom to switch lenders who offer lower interest rates or better services. However, a blanket ban on such charges, particularly for floating-rate loans, may raise concerns regarding lender sustainability and disincentive lending to high-risk borrowers and smaller firms.

Banks usually incur substantial upfront fixed costs like assessing creditworthiness, loan processing and administrative costs. Since Banks do not demand these costs as an upfront payment, which would risk default by borrowers, lenders typically spread them equitably over the loan tenure. PP charges are a way of ensuring that banks recover these costs by discouraging premature exits and making borrowers to stay with the banks longer. Moreover, PP charges play a crucial role in mitigating reclassification risk. In this context, it refers to a situation where borrowers initially assessed as high risk prepay their loans prematurely to improve their creditworthiness. Once they are reclassified to low-risk, they may refinance into cheaper loans with other institutions. This behaviour leaves the initial lenders to recover upfront costs and risk premiums despite having borne the initial credit risks. By restricting such early exits, PP charges stabilise the lender’s borrower pool and enable banks to offer discounted interest rates even to higher-risk borrowers. This directly enhances credit accessibility for MSMEs and underserved segments with weak credit scores that might otherwise face rejection or higher borrowing costs.

Prohibiting such charges might also incentivise other banks to free-ride on the efforts of incumbent banks who incur initial screening expenditures by luring their borrowers with low interest rates, resulting in a loss of money. Although one might argue that since borrowers voluntarily opt for floating rate loans to switch lenders flexibly, it might be counterproductive in the long run, where banks might increase their overall interest rates to recover these sunk costs and might hesitate to issue fresh loans to borrowers with credit risk. This might affect and narrow down the credit accessibility of MSMEs and small-time borrowers, whom the RBI Directions intend to protect and regulate.

Towards a Balanced Framework for Pre-Payment Charges: Possible Suggestions

The foregoing analysis underscores that completely barring regulated entities from levying PP charges is neither practical nor desirable in the long run. While protecting borrowers from unfair penalties is essential, it is equally important to recognise the legitimate concerns of lenders. Therefore, a more targeted regulatory approach must be adopted to address the equitable interests of borrowers and lenders. In light of the above, the authors offer the following suggestions to make this existing framework more equitable for all stakeholders:

Firstly, Lenders should be allowed to recover PP Charges only to the extent of legitimate upfront costs incurred if the borrower chooses to repay their loan early. Further, lenders must demonstrate specific losses or costs incurred, emphasising the need to demonstrate actual loss or specific economic harm to justify such charges. This approach would tie PP charges with economic rationale instead of acting as profit-making penalties and lender leverage. While it may be difficult to calculate precise costs on a case-by-case basis, the RBI could issue standardised estimates or slabs based on consultations with banks, audit firms, and consumer groups.

Further, PP charges, along with their calculation methodology and duration, should be clearly disclosed in loan agreements and Key Fact Statement (KFS) as mandated by the Directions for all regulated entities. This would enhance transparency, prevent hidden charges and ensure informed consent by borrowers.

Lastly, until the Directions are in force, banks should come up with innovative flexible loan products such as hybrid fixed-floating loans. Under this structure, loans would carry a fixed interest rate with PP charges during the initial years to recover upfront costs. After this period, loans could transition into a floating loan. Such structures would build loyalty and long-term relationships between lenders and borrowers, recover early-stage costs and also provide borrowers flexibility to refinance or switch when better opportunities arise.

Conclusion

The Directions on prepayment charges mark a progressive step towards building a more equitable lending in India, especially for individuals and MSMEs. By prohibiting PP charges on floating rate loans, the framework enhances transparency, improves refinancing flexibility, and promotes competition in the lending market. Nonetheless, this analysis also underscores that a purely pro-borrower approach of the RBI that ignores lenders’ concerns is neither feasible nor desirable for the lending market. A blanket ban on PP charges for floating rate loans has accompanying risks such as free-riding, cost recovery issues, and disincentivised lending, which necessitate a measured regulatory response. A framework that combines cost-based justifications for PP charges, robust disclosure requirements, and borrower rights and product innovations can achieve the twin goals of borrower protection and lender viability. As India moves toward a borrower-friendly credit regime, the targeted regulation of PP charges ensures more inclusive, responsible, and resilient lending practices.