With the RBI restricting the number of banks, and then who can own banks, they effectively narrow the playing field to a few entities, many of them owned by the government. The banks' lack of competition is compensated by RBI regulation, but that regulation sometimes leaves a lot to be desired. Especially when it comes to pre-payment penalties.
You'd think banks would love their money back, if you tried paying it back earlier. But no, it seems. They charge you a penalty for early payment, typically 2-3% of your outstanding balance. It's strange, this charge. Why wouldn't they want you to pay a fee just to pay back?
Their answer is that they're really scared of keeping money unused. The minute you pay back, they now have to lend that money out again, which they say takes time. And they lose interest in that time, which is why they need to charge you. But it's a hollow argument, because like all things financial they make a generic statement and oversimplify matters, or use complex terms like "asset-liability mismatch". The devil is in the details.
Most repayments now are "EMI" based — that is, you pay a part of principal and interest every month. Banks get repaid, in part, every month, and you pay the bulk of the interest on the loan in the first few payments. It's evident that the bank is getting repaid every month — and they don't get worked up about having to reinvest that money. But yes, the bank argues that such repayments can be planned against — in which case, can they remove the pre-payment penalty if we give them a three month notice?
Second, banks are supposed to borrow short-term and lend long-term. So in a situation where short term rates are low and longer term rates are high, they borrow in the short term (1 month, 6 months, a few years) and lend out for 3 year to 20 year loans, and make the profit in the "spread". Since they don't match tenures, they can tweak their short term borrowing on a regular basis, because it's short term money anyhow — that is, they can borrow lesser next month if they get more prepayments this month. And consider that most banks even borrow overnight from the RBI (at 7.25% today); why is it a problem then if you prepay your loan? Doesn't that save them the 7.25% they have to pay the RBI for at least that much money? Why should we, the borrowers, have to pay a penalty?
And then, there's a clincher. For the bank, after a while, it's very profitable to take the money back. You've already paid a bulk of the interest.
Take a car loan for three years at 11% per annum: After two years, you have a 1.85 lakh outstanding balance, and the remaining 12 months will cost you just Rs. 11,220 in interest. The bank effectively gets, for the last year, 6.1% interest on the money. If you chose to prepay the remaining amount after two years, the bank could take it and if they make more than 6.1% off the money, they've lost nothing. Those kind of rates are now easily available with 1 year government treasury bills (which offer 8.2% today!) — the safest form of parking your money.
In fact, if you keep the loan on, you will keep repaying mostly principal and give them tiny bits of interest — and there is a risk that you might still default. The banks are actually better off if you pre-pay at this point. Why should the bank make you pay a penalty? It should in fact give you an incentive to pre-close the loan. (Where is my toaster?)
For you, it may still be better to repay; for one, our tax rules don't allow you to offset interest costs as an individual, which means you'll pay tax on the interest you earn but you don't get to save tax on the interest you pay (on, say, a car loan). This makes the interest arbitrage useless. Secondly, there's the peace of mind when you repay. And finally, it allows you to get another, perhaps larger loan in the near future; a good repayment history and lower debt helps.
The other reason you must repay is when banks play dirty with interest rates. They'll offer you a rate — say "Base Rate+3%" when you sign up. Then if RBI cuts rates, your bank will retain your loan at the same rate, but they will offer new customers "Base Rate + 2%". At this point your only alternative is to switch, to make them behave; but the prepayment penalty is a sword on your head. It should be taken out.
The RBI has expressed a desire to remove such penalties but hasn't yet done anything concrete in that regard. The National Housing Bank has banned pre-payment penalties for housing NBFCs (like HDFC and LIC Housing Finance) where borrowers repay funds from their own sources, but they can charge you if you refinance the loan with a different lender. While this is some relief, it is still very anti-competitive; what difference does it make to the financier either way? Early return of capital is a risk they have to take, and with floating rate loans it's not even that much of a risk.
Many banks have a partial pre-payment facility for no charge; but recently, they have started setting restrictions like you can't prepay more than 25% of your balance each year (any more and you need to pay the entire amount, and thus pay the pre-payment penalty). This again is usurious, and when all banks begin to adopt such practices, it is for the regulator to step in and say that it is not allowed.
Banks threaten to raise interest rates across the board if there is a blanket ban, but banks have always made such threats. (Deregulate the savings rate, and we'll raise costs for everyone, for instance) We have to call that bluff — and as new banks come in as competition, banks will behave.
If you ask me, the pre-payment penalty should be completely disallowed. As an intermediate step, it might be useful to signal the move by disallowing such penalties if the borrower has paid back over half the interest that he would paid for the entire period. They'll tell you it's complicated. It's not. It's just the sum of whatever interest you've paid till now and whatever you will pay, if the loan goes all the way to the end. (For a three year car loan of 500,000 at 11%, you pay more than half the total interest of Rs. 90,000 in the first 12 months.)
It's is indeed strange that we should be charged a fee for the act of returning borrowed money. They now lend you money with a smile, and take it back with a frown. This isn't how it was meant to be.