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Penal Charges in Loan Accounts

Reserve Bank of India (RBI) has issued circular on penal charges in loan accounts to ensure fair lending practice by the regulated entities.

Why are penal interest / charges levied?

  • The intent of levying penal interest / charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender. 
  • Penal interest / charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest. 

What is rationale behind the circular?

Under the extant guidelines, lending institutions have the operational autonomy with regard to levy of penal rates of interest. 

During supervisory reviews of regulated entities (REs) it was observed that –

  • Many REs use penal rates of interest, over and above the applicable interest rates, in case of defaults / non-compliance by the borrower with the terms on which credit facilities were sanctioned.
  • Divergent practices amongst the REs with regard to levy of penal interest / charges are leading to customer grievances and disputes.

In view of the above observations, Reserve Bank of India (RBI) had issued draft circular on penal charges in loan accounts for comments by the stakeholders. RBI has now released the instructions on penal charges in loan accounts.

What are the instructions on penal charges in loan accounts?

On a review of the practices followed by REs for charging penal interest / charges on loans, the following instructions are issued for adoption.

  1. Penalty, if charged, for non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances.
  2. There shall be no capitalisation of penal charges i.e., no further interest computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account.
  3. REs shall not introduce any additional component to the rate of interest and ensure compliance to these guidelines in both letter and spirit.
  4. REs shall formulate a Board approved policy on penal charges or similar charges on loans, by whatever name called.
  5. The quantum of penal charges shall be reasonable and commensurate with the non-compliance of material terms and conditions of loan contract without being discriminatory within a particular loan / product category.
  6. The penal charges in case of loans sanctioned to ‘individual borrowers, for purposes other than business, shall not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.
  7. The quantum and reason for penal charges shall be clearly disclosed by REs to the customers in the loan agreement and most important terms & conditions / Key Fact Statement (KFS) as applicable, in addition to being displayed on REs website under Interest rates and Service Charges.
  8. Whenever reminders for non-compliance of material terms and conditions of loan are sent to borrowers, the applicable penal charges shall be communicated. Further, any instance of levy of penal charges and the reason therefor shall also be communicated.

Which banks / institutions will be covered under the instructions?

  • All Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks, excluding Payments Banks)
  • All Primary (Urban) Co-operative Banks
  • All NBFCs [including Housing Finance Companies (HFCs)]
  • All India Financial Institutions (AIFIs) –
    • Export-Import Bank of India (EXIM Bank)
    • National Bank for Agriculture and Rural Development (NABARD)
    • National Housing Bank (NHB) 
    • Small Industries Development Bank of India (SIDBI) 
    • National Bank for Financing Infrastructure and Development (NaBFID)

Which loans will be covered by the instructions?

The instructions on penal charges in loan accounts will be applicable in respect of all the fresh loans availed / renewed from the effective date. 

Which products are exempted from the purview of the instructions?

The instructions will not apply to Credit Cards, External Commercial Borrowings, Trade Credits and Structured Obligations which are covered under product specific directions.

From when are the instructions applicable?

(Updated January 17, 2024)

The instructions were to come into effect from January 01, 2024 but the timeline has been extended by 3 months. 

Accordingly, REs shall ensure that the instructions are implemented in respect of all the fresh loans availed from April 01, 2024 onwards. In the case of existing loans, the switchover to new penal charges regime shall be ensured on the next review / renewal date falling on or after April 01, 2024, but not later than June 30, 2024.


References

Reserve Bank of India. (2023, April 12). 'Draft Circular on Fair Lending Practice - Penal Charges in Loan Accounts'. Retrieved from https://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=4254

Reserve Bank of India. (2023, August 18). 'Fair Lending Practice - Penal Charges in Loan Accounts'. Retrieved from https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12527&Mode=0

Reserve Bank of India. (2023, December 29). 'Fair Lending Practice - Penal Charges in Loan Accounts: Extension of Timeline for Implementation of Instructions'. Retrieved from https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12585&Mode=0

Reserve Bank of India. (2023, April 12). 'RBI releases Draft Circular on Fair Lending Practice - Penal Charges in Loan Accounts'. Retrieved from https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=55506

Reserve Bank of India. (2024, January 15). 'FAQ - Fair Lending Practice - Penal Charges in Loan Accounts'. Retrieved from https://www.rbi.org.in/Scripts/FAQView.aspx?Id=162


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