Abolishing pre penalty on loans could encourage banks to hike interest rates on loans so as to pass their burden to customers, RBI Deputy Governor Usha Thorat said.

"There is a chance that banks may pass on this burden to customers (if the prepayment penalty is abolished)," Thorat said.

A prepayment penalty is a provision in the loan contract with the lender that states that in the event the customer closes off the loan before maturity, he will have to bear a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest.

Usually opting for a prepayment penalty clause in the contract allows the customer to avail loans at lower interest rates as this acts as an indicative of the credit worthiness of the customer.

Anti-monopoly watchdog Competition Commission of India had recently said that it felt that penalizing borrowers who close off their loans pre maturely is a violation of competition laws and that it would fine banks or ask them to stop imposing pre penalty on borrowers.

Speaking on this note Thorat said that the commission had intervened in the process as some banks were levying huge amounts of penalty on borrowers on account of prepayment of loans.

Banks usually impose penalties in the range of 2-3 % on such issues. If not done, their interest rate earnings would be hampered and also increase lending risk, banks say defending themselves.

In such a situation, banks may be forced to hike lending rates to all borrowers to compensate this risk, bankers said.