The Reserve Bank of India (RBI) has introduced new rules aimed at easing the financial burden on individuals and micro, small, and medium enterprises (MSMEs). Currently, many banks and financial institutions charge a prepayment penalty of 4% to 5% of the outstanding loan amount. The RBI’s latest proposal seeks to eliminate these charges and foster a more borrower-friendly lending environment.
However, this move raises important questions: How will it impact financial institutions like banks and NBFCs? And what does it mean for investors? Let’s break it down.
What’s Happening?
Based on stakeholder feedback, the RBI announced a major policy decision on July 2, 2025, issuing fresh guidelines on foreclosure charges and prepayment penalties. Under the new rules, banks and financial institutions will no longer be allowed to charge prepayment fees on floating rate loans. These guidelines will apply to all loans sanctioned or renewed on or after January 1, 2026.
The rules cover individual borrowers and Micro and Small Enterprises (MSEs), even if the loans are for business purposes. Previously, banks and NBFCs could not impose prepayment penalties on floating rate loans taken for non-business purposes. Now, that exemption has been extended to business loans as well.
The RBI clarified that the move is intended to make credit more accessible and less cumbersome — especially for the MSE segment. This decision follows a review that found inconsistent practices among lenders, often leading to disputes with borrowers.
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Zero Foreclosure Charges on Floating Rate Loans
Here are the key changes under the RBI’s revised rules:
Who’s Covered: Commercial banks (except Small Finance Banks, Regional Rural Banks, and Local Area Banks), Tier-4 Urban Co-operative Banks, NBFCs–Upper Layer, and All India Financial Institutions can no longer levy prepayment fees on floating rate loans to individuals and MSEs for business use.
Wider Inclusion: For non-business loans up to Rs 50 lakh, even Small Finance Banks, Regional Rural Banks, Tier-3 Urban Co-operative Banks, State/Central Co-operative Banks, and NBFCs–Middle Layer are prohibited from charging such fees.
No Conditions: The origin of funds used for prepayment does not affect this rule. There is also no mandatory lock-in period before borrowers can prepay.
Overdrafts & Cash Credit: Prepayment charges on these accounts are also disallowed if the borrower provides timely notice and closes the account.
MSME Lending: Growth and Asset Quality
According to CRIF High Mark, credit to the MSME sector crossed Rs 40 trillion by March 2025, recording a robust 20.1% year-on-year growth. This surge was supported by strengthened priority sector lending norms, favourable government schemes, and improved digital infrastructure.
That said, the number of active loans rose by just 1.3% in FY25, reaching 21.45 million. This is a significant slowdown compared to the 23.7% growth in FY24.
MSME loan portfolios continue to grow steadily, and their asset quality has improved over time.
The portfolio at risk (31–90 days) remained steady at 1.7%. Risk in the 91–180 days category improved to 1.2%. Loans overdue for more than 180 days dropped to 5.7%, marking a 0.9% improvement year-on-year.
What Does This Mean for Investors?
The RBI’s new regulation is expected to intensify competition in the lending space. Borrowers will now have greater flexibility to repay loans early or switch lenders without incurring penalties. This could force banks and NBFCs to offer more attractive terms and focus on customer retention.
While this is good news for borrowers, it could mean a dip in non-interest income for banks and NBFCs that earlier benefited from prepayment charges.
However, as noted by The Financial Express, Sanket Agrawal, Chief Strategy Officer at SBFC Finance, pointed out that the regulation applies only to floating rate loans sanctioned after January 1, 2026. Therefore, it won’t affect current loan portfolios. He also emphasised that most borrowers typically do not repay long-term loans in the early years, suggesting that the impact will be gradual.
What’s Next?
Over the past 13 years, the elimination of prepayment penalties has gradually expanded — from home loans to NBFCs, housing finance companies (HFCs), and now MSME loans.
With the rule set to take effect on January 1, 2026, lenders have adequate time to review and realign their strategies. The RBI has also mandated that all loan agreements must clearly state whether prepayment charges apply — both in the sanction letter and the Key Facts Statement. If a lender fails to disclose this upfront, it cannot levy any such fee.
In the long run, this reform is a positive step toward a more transparent, borrower-centric, and competitive lending landscape. For investors and financial institutions alike, it signals a shift toward efficiency and customer-first practices — an evolution worth watching closely.
*The article is for information purposes only. This is not investment advice.
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