The Reserve Bank of India (RBI) has directed banks and non-banking financial companies (NBFCs) not to levy penal interest that is added to the rate of interest rate charged on the loans.

As per the RBI circular issued on Friday, lenders can levy penalty for default by borrowers as ‘penal charges’. But there can’t be capitalisation of penal charges. This means that no further interest can be computed on such charges. The normal procedures for compounding interest in the loan account, however, will not be affected.

Lenders would be able to levy only ‘reasonable’ penal charges ‘commensurate with the non-compliance of loan contract’, the RBI said in its guidelines on Penal Charges in Loan Accounts under the Fair Lending Practice. It can’t be discriminatory within a particular loan or product category.

Banks should not introduce any additional component to the rate of interest and ensure compliance with these guidelines in both letter and spirit, the RBI said. The banks will have to formulate a board approved policy on penal charges or similar charges on loans.

The instructions, however, will not apply to credit cards, external commercial borrowings, trade credits and structured obligations which are covered under product-specific directions, the RBI said.

The new guidelines will come into effect from 1 January 2024.

The penal charges in case of loans sanctioned to individual borrowers, for purposes other than business’ such as home loans and personal loans, cannot be higher than that charged to non-individual borrowers. 

Most important terms and conditions/Key Fact Statement (KFS) as applicable, should be displayed on banks’ websites under interest rates and service charges section.

The quantum and reasons for penal charges must be clearly disclosed to the customers in the loan agreement.

Whenever reminders for non-compliance of loan contracts are sent to borrowers, the applicable penal charges will have to be communicated. Any instance of levy of penal charges and the reason therefore shall also be communicated, the RBI said.

Banks need to carry out appropriate revisions in their policy framework and ensure implementation of the instructions in respect of all the fresh loans availed or renewed from the effective date of 1 January 2024.

In the case of existing loans, the switchover to new penal charges regime shall be ensured on next review or renewal date or six months from the effective date of this circular, whichever is earlier.

The RBI said these instructions will not apply to credit cards, external commercial borrowings, trade credits and structured obligations which are covered under product-specific directions.

The new guidelines are applicable to all commercial banks, small finance banks (except payment banks), NBFCs including housing finance companies, primary urban co-operative banks and other financial institutions such as Exim Bank, Nabard, SIDBI and NaBFID.

Why RBI came out with new guidelines

The RBI found that many entities regulated by it were levying 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.

“The intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline and such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest,” the RBI said.