RBI’s Positive Directive: Banks Prohibited from Charging Penal Interest.

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The Reserve Bank of India (RBI) took a significant step on Friday by unveiling guidelines to oversee the imposition of penal charges by banks and lenders in cases of missed payments or non-compliance by borrowers.

In a circular, the central bank outlined its efforts to instill fairness and clarity in how penal interest is disclosed by Regulated Entities (REs). It has come to the RBI’s attention that many REs impose penal interest rates beyond the applicable interest rates when borrowers default or do not adhere to the terms of their credit agreements.

RBI highlighted that the purpose of imposing penal interest or charges is to foster credit discipline. It emphasized that these charges should not serve as a tool for boosting revenue “beyond the contracted rate of interest.”

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Despite this intention, discrepancies have been identified in how REs apply penal interest/charges, leading to customer grievances and conflicts.

To address these concerns, the RBI has provided specific directions:

**RBI’s Stance on Penal Interest Charges:**

The RBI clarified that any penalties for non-compliance with key terms of a loan agreement should be categorized as ‘penal charges,’ distinct from ‘penal interest’ added to the interest rate on advances. It emphasized that these charges should not accrue interest themselves. This adjustment, however, will not affect standard procedures for calculating interest on loan accounts.

The central bank emphasized that REs should not introduce any additional components to the interest rate and should adhere to these guidelines thoroughly.

Moreover, RBI instructed REs to devise a Board-approved policy detailing penal charges or similar fees on loans.

 

**Quantum and Disclosure of Penal Charges:**

The RBI also emphasized that the magnitude of penal charges should be reasonable and proportional to the breach of terms in the loan agreement. This approach should avoid discrimination against specific loan/product categories.

For loans provided to “individual borrowers, for purposes other than business,” the penal charges must not surpass those applicable to non-individual borrowers for similar non-compliance.

Transparency is crucial, as the RBI insisted that the quantum and rationale for penal charges must be clearly stated in the loan agreement and other essential documents, such as the Key Fact Statement (KFS). These details should also be prominently displayed on the REs’ websites under Interest Rates and Service Charges.

**Communication and Implementation:**

When notifying borrowers about non-compliance with loan terms, REs must communicate the associated penal charges. Any instance of levying penal charges and the underlying reason must also be conveyed to borrowers.

The instructions issued by the RBI are scheduled to take effect from January 1, 2024. REs are expected to revise their policies accordingly and apply the instructions to all new loans obtained or renewed after the effective date.

For existing loans, the transition to the new penal charges structure should occur during the next review or renewal, or within six months of the circular’s effective date, whichever comes earlier.

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