The Reserve Bank of India (RBI) has proposed new regulations on how lenders can charge penalties on loans. Many lenders currently charge extra interest, known as penal interest, when a borrower fails to make their loan repayments on time or violates the loan terms. However, the RBI believes that penal interest can sometimes be misused by lenders and has proposed that penalties should be charged as a fixed fee instead. The purpose of these penalties is to compensate the lender for the extra work involved in managing a delinquent borrower and to encourage borrowers to repay their loans on time.
The RBI has found that different lenders apply penal interest in different ways, leading to complaints and disputes from customers. The proposed regulations state that penalties must be charged in a reasonable and transparent way and must not be added to the principal amount owed. Lenders will be allowed to adjust the credit risk premium, which is the extra interest charged to cover the risk of a borrower defaulting, if a borrower's credit risk profile changes.
The RBI has issued guidelines for lenders to follow when imposing penalties on borrowers. These include not adding any extra interest components to the loan interest rate and disclosing penalty charges in loan agreements and on their websites. Lenders must also have a board-approved policy on penalty charges and communicate applicable charges to borrowers when sending reminders for loan repayments. The guidelines will come into effect soon.
Below are the key points from the RBI circular dated April 12, 2023
1. Lenders should only charge penal charges and not penal interest on loans in the event of a borrower's default or non-compliance with loan terms.
2. The penal charges should be reasonable and transparent, and not be used to increase revenue over the agreed-upon interest rate.
3. There shall be no capitalisation of penal charges, meaning no further interest will be computed on such charges.
4. The quantum of penal charges shall be proportional to the defaults/non-compliance of material terms and conditions of loan contract beyond a threshold, which is determined by the REs and shall not be discriminatory within a particular loan/product category.
5. The penal charges and the conditions precedent shall be clearly disclosed to the customers in the loan agreement and most important terms & conditions/Key Fact Statement (KFS), and shall be displayed on REs website under Interest rates and Service Charges.
6. Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges shall also be communicated.
7. REs shall ensure that there is a clearly laid down Board approved policy on penal charges or similar charges on loans.
8. The operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examination by the RBI.
9. These instructions shall come into effect from a date to be indicated in the final circular, and REs may carry out appropriate revisions in their policy framework and ensure implementation from the effective date.
Note: These instructions do not apply to credit cards, which are covered under product-specific directions.
Conclusion
In conclusion, the Reserve Bank of India (RBI) has issued draft guidelines on levying penal charges on loan accounts to ensure that penal charges are levied in a reasonable and transparent manner, and not as a compounding interest rate. The RBI has observed that Regulated Entities (REs) have been misusing penal interest and charges, and that there are differences in how they apply such charges, leading to client complaints and disputes. To address this issue, the RBI has provided guidelines for determining interest rates on credit facilities, treating penalties as 'penal charges' and not as 'penal interest', disclosing penal charges to customers, and ensuring there is a clearly laid down policy on penal charges. These guidelines will come into effect from a date to be indicated in the final circular, and REs are expected to carry out appropriate revisions in their policy framework and ensure implementation from the effective date.
The author is a Chartered Accountant with 2 decades of experience into Accounting, Taxation, Auditing, Risk & Compliance, Credit Controls, Due diligence. Currently, the author is the founder and managing partner at RRL Global services.
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