The Reserve Bank of India (RBI) has released fresh directives targeted at regulated entities (REs) concerning punitive fees within loan accounts. The goal of these guidelines is to prevent REs, including commercial banks, urban co-operative banks, non-banking finance companies (including housing finance companies), and All-India Financial Institutions, from exploiting penal interest/charges as a means of augmenting revenue beyond the agreed interest rates. Effective from January 1, 2024, the RBI’s instructions seek to curb any misuse of penal charges by aligning them with fair lending practices.
Under the rubric of ‘Fair Lending Practice – Penal Charges in Loan Accounts’, the RBI has stipulated that penalties for borrowers failing to comply with the fundamental terms of loan contracts should be classified as ‘penal charges’. These charges must not manifest as ‘penal interest’ added to the prevailing interest rate on loans. Notably, the practice of capitalising penal charges—calculating additional interest on these charges—is prohibited.
Compliance with these guidelines is imperative. REs are forbidden from introducing supplementary elements to the interest rate structure and must fully adhere to the stipulated guidelines. They are mandated to formulate a board-approved policy on penal charges, or other similar charges associated with loans. The RBI underscores the necessity for penal charges to be reasonable and proportionate to the degree of non-compliance with loan contract terms, avoiding discriminatory practices within specific loan/product categories.
For loans issued to ‘individual borrowers, for non-business purposes’, the imposed penal charges should not exceed those applied to non-individual borrowers for comparable breaches of material loan conditions. REs are obliged to transparently communicate the quantum and rationale for penal charges to customers in loan agreements, along with the most salient terms, conditions, and Key Fact Statement (KFS) where applicable. This information should also be displayed on the REs’ websites under the interest rates and service charges section.
When sending reminders to borrowers concerning non-compliance with loan terms, REs must communicate the relevant penal charges. Instances of penal charge imposition and their grounds must also be conveyed to borrowers. REs should adapt their policy framework to adhere to these instructions for all newly availed or renewed loans starting from the effective date.
Regarding existing loans, the transition to the new penal charges system should be ensured during the subsequent review or renewal, or within six months of the circular’s effective date, whichever comes first. However, standard procedures for interest compounding in loan accounts will remain unaffected.
It’s important to note that these directives do not pertain to credit cards, external commercial borrowings, trade credits, and structured obligations, which are governed by product-specific guidelines. The RBI emphasises that the intent behind imposing penal interest/charges is primarily to foster credit discipline, rather than serving as a tool for generating revenue beyond the agreed interest rates. The RBI’s decision to issue these guidelines stems from varying practices among REs, which have resulted in customer complaints and disputes.
