Many regulated entities (REs) use penal rates of interest, over and above the applicable interest rates, in case of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned. To review extant regulatory guidelines on levy of penal interest, the Reserve Bank of India (RBI) released 'draft circular on fair lending practice - penal charges in loan accounts' seeking stakeholder comments.
In the draft circular, RBI says, "The intent of levying penal interest or 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 or charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest. However, supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest and charges leading to customer grievances and disputes."
However, the central bank says these instructions will not apply to credit cards which are covered under product-specific directions.
Here are the instructions issued by RBI to lenders or REs...
(i) Determination of interest rates on credit facilities, including conditions for reset of interest rates, will be strictly governed by the relevant regulatory instructions issued in this regard. REs shall not introduce any additional component to rate of interest.
(ii) Penalty, if charged, for default or 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. 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.
(iii) It needs to be recognised that the rate of interest on a loan includes an appropriate credit risk premium reflecting the credit risk profile of the borrower. If the credit risk profile of the borrower undergoes change, REs will be free to alter credit risk premium as per the contracted terms and conditions in terms of extant instructions.
(iv) The quantum of penal charges shall be proportional to the defaults or non-compliance of material terms and conditions of the loan contract beyond a threshold. This threshold is to be determined by the REs and shall not be discriminatory within a particular loan or product category.
(v) 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.
(vi) Penal charges and the conditions precedent, therefore, shall be clearly disclosed by REs to the customers in the loan agreement and most important terms & conditions (T&C) or key fact statement (KFS) as applicable, in addition to being displayed on REs website under 'Interest rates and Service Charges'.
(vii) Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges shall also be communicated.
(viii) The REs shall ensure that there is a clearly laid down board-approved policy on penal charges or similar charges on loans, by whatever name called.
(ix) The operationalisation of the 'penal charges' in place of 'penal interest' will be subject to appropriate review during supervisory examination by RBI.
(x) 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.
Stakeholders may submit their comments on the draft circular by 15 May 2023 to chief general manager, department of regulation, central office, RBI, 12th Floor, Central Office Building, Shahid Bhagat Singh Marg, Fort, Mumbai – 400001 or by email
[email protected] with the subject line "Draft Circular on Fair Lending Practice - Penal Charges in Loan Accounts".