Prepayment penalty ban on home loans comes at a cost

The stricture by the housing finance regulator, the National Housing Bank (NHB), on borrowers being forced to fork out a penalty for prepaying home loans is great from a media point of view. The NHB gains brownie points by showing that it cares for the customer and the customer of housing loans believes that it is great to prepay housing loans without any penalty.

NHB should have thought through this prepayment waiver. If it had done so, it would never have come out with this media-friendly stricture. The waiver actually increases costs for home loan borrowers as housing finance companies (HFC) will now have to build in prepayment risks into home loan costs.

[caption id=“attachment_114300” align=“alignleft” width=“380” caption=“When there is no prepayment penalty, only the customer who prepays gains. But this increases the risks for the housing finance company, which will then raise loan prices for everyone. Nickname/Flickr”]  [/caption]

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Some customers will benefit, but the entire community of customers will lose. When there is no prepayment penalty, only the customer who prepays gains. But this increases the risks for the housing finance company, which will then raise loan prices for everyone. India does not have a good hedging market for interest rates, and housing finance companies will only price the risk imperfectly, leading to higher than warranted costs for the consumer.

Why is there a risk for the HFC on prepayments without penalty? In a perfect market, the HFC will give out long-term loans, typically for 15 to 20 years, to home loan borrowers. The long-term loans given out form the asset base of the company and the assets will be of around 10 years’ duration (bond mathematics).

The HFC will then raise 10-year duration loans from the market to match the asset. The loans raised by the HFC form the liability part of the balance-sheet. A 10-year asset matching a 10-year liability balance out each other and the HFC earns a spread on the difference between borrowing and lending rates without incurring a gapping risk. (Risk of asset-liability mismatches).

The HFC now runs the risk of (a) default by borrowers and (b) prepayment by borrowers. The default risk is taken care of by credit controls and adequate capital to back the loans while the prepayment risk is taken care of by charging a prepayment penalty. The risk of prepayment is that the HFC will be left with a liability (the loan it has taken) it will have to service irrespective of whether the asset continues to exist or not.

The lender to the HFC will definitely ask for a penalty for closing out the loan. Hence prepayment is a loss to the HFC and it increases the risk to the HFC as it leads to an asset-liability mismatch.

Let us take an example where an HFC has 10 home loans outstanding with a duration of 10 years each and one loan is prepaid. The HFC will be left with nine home loans outstanding but its liabilities (HFC’s borrowings to finance the home loans) will still have a duration of 10 years, as it cannot prepay its borrowings. The asset base duration will have come down due to the prepayment while the liability base duration will remain the same, leading to an asset-liability mismatch.

HFCs impose prepayment penalties to take care of prepayment risks. The NHB should now address the way prepayment risks will be taken care of by HFCs or it will have to insure prepayment risks at zero cost to HFCs to compensate the latter for potential losses.

If not, HFCs will try to price this risk in by raising rates for all.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a website for investors.