Fair Lending Practice – Penal Charges In Loan Accounts – RBI

The RBI said penal charges in loan accounts should be used to promote credit discipline and not as a “revenue enhancement tool”.

New guidelines for the imposition of penal interest rates on loan accounts were released by the Reserve Bank of India (RBI) on Friday. The new regulations state that “penal charges” rather than “penal interest” that are added to the rate of interest paid on the advances shall be used to describe the penalty for non-compliance with the loan terms by the borrower. When a customer does pay their due installment on time, penalties are applied to the loan.

The guidelines issued by RBI titled “Fair Lending Practice – Penal Charges in Loan Accounts” also state that there shall be no capitalization of penal charges. This means that no further interest will be computed on such charges.

“However, this will not affect the normal procedures for compounding of interest in the loan account,” the central bank said in an announcement. The new regulations specify that “penal interest” of any percentage will be changed to “penal charge” and that the interest rate will remain the same. In April of this year, the RBI published a draft for penal charges.

The revised guidelines also stipulate those penal charges for loans granted to “individual borrowers, for purposes other than business,” shall not be greater than penal charges for identical violations of material terms and conditions that apply to non-individual borrowers. It further stated that anytime borrowers are provided reminders for non-compliance with material terms and conditions of the loan, the related penal charges must be communicated. Furthermore, any occurrence of the imposition of penal charges, as well as the rationale for it, must be communicated.

Furthermore, Regulated Entities (REs) would be permitted to organize a board to authorize penal or similar charges on loans. “The quantum of penal charges shall be reasonable and commensurate with non-compliance of material terms and conditions of loan contract without being discriminatory within a particular loan/product category,” the RBI stated. “The quantum and reason for penal charges shall be disclosed to customers by REs in the loan agreement and most important terms and conditions / key fact statement (KFS), as applicable, in addition to being displayed on REs website under Interest rates and Service Charges,” it stated. These instructions will take effect on January 1, 2024.

The REs have been instructed to make suitable changes to their policy framework and ensure that the instructions are followed for any new loans obtained or renewed after the effective date. “In the case of existing loans, the switchover to the new penal charges regime shall be ensured on the next review or renewal date or six months from the effective date of these instructions, whichever is earlier,” said the RBI.

All banking entities governed by the RBI, including commercial banks, cooperative banks, NBFCs, home finance companies, and All India Financial Institutions including EXIM Bank, NABARD, NHB, SIDBI, and NaBFID, would be subject to the new regulations. Credit cards, outside commercial borrowings, trade credits, and structured liabilities are exempt from these rules since they are covered by product-specific guidelines.

The RBI claims that the purpose of these regulations is to “inculcate a sense of credit discipline”. Nevertheless, it issues a warning, stating that “such charges are not intended to be used as a revenue enhancement tool over and above the contracted rate of interest”.