The Reserve Bank of India (RBI) has taken a significant step to reform the way penalties are levied on loan accounts. The issuance of new guidelines comes as a response to the observed practice among several banks of imposing penal rates of interest as an additional charge on borrowers who fail to comply with the terms of their credit agreements. These fresh directives are scheduled to take effect from January 1, 2024.

 

In line with the circular, any penalty imposed for non-compliance with the terms and conditions of a loan contract by the borrower will be considered as 'penal charges.' These charges will not be applied as 'penal interest,' which is usually added to the standard interest rates on advances. Additionally, the circular strictly prohibits the compounding of penal charges, ensuring that no further interest is computed based on such charges. However, this modification will not disrupt the customary practices of compounding interest within the loan account.

 

To ensure compliance with these guidelines, RBI has urged banks to abstain from introducing any additional component to the interest rate. The circular mandates banks to devise a board-approved policy concerning penal charges or similar fees on loans, irrespective of the nomenclature.

The quantum of penal charges must be rational and proportionate to the breach of terms and conditions in the loan contract. Importantly, these charges must not discriminate within specific loan or product categories.

 

For loans granted to 'individual borrowers for purposes other than business,' such as home loans and personal loans, the penal charges must not surpass those applicable to non-individual borrowers for similar breaches of the loan contract.

 

The RBI underlines the necessity for banks to explicitly disclose the amount and rationale behind penal charges in the loan agreement. Key terms and conditions, as well as the Key Fact Statement (KFS) where applicable, should be prominently displayed on the banks' websites under the sections dedicated to Interest Rates and Service Charges.

 

When borrowers are sent reminders concerning non-compliance with the loan contract's terms and conditions, the corresponding penal charges must be communicated. Any imposition of such charges and the underlying rationale should also be effectively communicated to borrowers.

 

Banks are expected to revise their policy frameworks in accordance with the new guidelines and apply them to all fresh loans availed or renewed from January 1, 2024. In cases of existing loans, the transition to the new penal charges regime should be executed at the next review or renewal date or within six months from the circular's effective date, whichever is earlier.

 

The RBI emphasizes that the intention behind levying penal interest or charges is primarily to foster credit discipline. These charges are not intended to serve as tools for revenue enhancement, exceeding the agreed-upon interest rate. However, discrepancies in practices regarding the imposition of penal interest/charges among banks have led to customer grievances and disputes, prompting the need for these unified guidelines.

 

The RBI's circular, dated August 18, 2023, marks a significant stride in promoting transparency and fairness in the realm of loan penalties. It is applicable to commercial banks, small finance banks (excluding payment banks), NBFCs (including housing finance companies), and other financial institutions like SIDBI and EXIM banks,.