The Reserve Bank of India has issued fresh guidelines for regulated entities (REs) on penal charges in loan accounts to ensure that penal interest/ charges is not used as a revenue enhancement tool by them, over and above the contracted rate of interest.

The central bank’s instructions for the REs (all commercial banks, urban co-operative banks, non-banking finance companies, including housing finance companies and All-India Financial Institutions) shall come into effect from January 1, 2024.

Penalty, if charged, for non-compliance of the material terms and conditions of the loan contract by the borrower should be treated as ‘penal charges’ and cannot be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances, according to instructions relating to ‘Fair Lending Practice – Penal Charges in Loan Accounts’.

There should be no capitalisation of penal charges — that is no further interest computed on such charges.

However, this will not affect normal procedures for compounding of interest in the loan account.

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Compliance with guidelines

RBI said the REs cannot introduce any additional component to the rate of interest and should ensure compliance with these guidelines in both letter and spirit.

The REs are required to formulate a board-approved policy on penal charges or similar charges on loans, by whatever name called.

The central bank emphasised that the quantum of penal charges should be reasonable and commensurate with non-compliance with the material terms and conditions of the loan contract, without being discriminatory within a particular loan/ product category.

The penal charges in case of loans sanctioned to ‘individual borrowers, for purposes other than business’, should not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.

The quantum and reason for penal charges should be clearly disclosed by the REs to the customers in the loan agreement, and the most important terms & conditions / Key Fact Statement (KFS) as applicable, in addition to being displayed on the REs’ website under interest rates and service charges.

Whenever reminders for non-compliance of the material terms and conditions of the loan are sent to borrowers, the applicable penal charges should be communicated, RBI said.

Further, any instance of levy of penal charges and the reason should also be communicated.

REs may carry out appropriate revisions in their policy framework and ensure implementation of the instructions in respect of all the fresh loans availed/ renewed from the effective date.

Existing loans

In the case of existing loans, the switchover to the new penal charges regime should be ensured on the next review or renewal date, or six months from the effective date of this circular, whichever is earlier.

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These instructions will, however, not apply to credit cards, external commercial borrowings, trade credits and structured obligations, which are covered under product-specific directions.

“The intent of levying penal interest/ charges is essentially to inculcate a sense of credit discipline, and are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest. However, supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest/ charges, leading to customer grievances and disputes,” the central bank said.