RBI issues guidelines to regulate penal charges by banks

The RBI observed that many lenders charge penal rates over and above the applicable interest rate on loans in case of defaults that breach the terms of credit facilities.

In bid to provide relief to borrowers the Reserve Bank of India (RBI) on Friday directed banks and non-banking financial companies (NBFCs) not to jack up interest in the case of defaults and give retail customers an option to switch from floating rate to fixed rates.

As per a notification issued by the RBI, when a customer defaults or is not able to comply with the terms of borrowing, lenders can levy penalty, but from the beginning of 2024 they will not be allowed to charge any interest on such penalty.

“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 in the notification titled ‘Fair Lending Practice - Penal Charges in Loan Accounts’.

The new guidelines will come into effect from January 1, 2024. So from the beginning of the next calendar year there shall be no capitalisation of penal charges. This means lenders can impose a penalty but no further interest can be computed on such charges.

Currently, most of the banks and NBFCs levy 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.

As per the existing RBI guidelines, “banks shall formulate a Board approved policy for charging penal interest on advances which shall be fair and transparent.” In the amended guidelines, which will come into effect from January 1, 2024, this section will be deleted.

A new section is inserted in the guideline, which reads: “Penalty, if charged, for 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.”

However, the new guideline will not affect the normal procedures for compounding of interest in the loan account.

In a separate notification, the RBI directed all regulated entities that include banks and NBFCs to “clearly communicate to the borrowers about the possible impact of change in benchmark interest rate on the loan leading to changes in EMI and/or tenor or both.”

At the time of reset of interest rates, lenders shall provide the option to the borrowers to switch over to a fixed rate as per their Board approved policy. The policy, inter alia, may also specify the number of times a borrower will be allowed to switch during the tenor of the loan, the RBI said.

The central bank has directed lenders to ensure that these new rules apply to the existing as well as new loans by December 31, 2023. “All existing borrowers shall be sent a communication, through appropriate channels, intimating the options available to them,” the RBI noted.

This comes after an increase in RBI’s base lending rate (to banks) - repo rate - of 250 basis points during the last fiscal year to 6.5% currently. This has resulted in a corresponding hike in interest rates across loan categories such as home, personal and auto, leading to a rejig in borrowers’ EMIs and loan tenures.

The RBI also asked the banks to formulate a board-approved policy on penal charges or similar levies on loans. Further, the quantum of penal charges should be "reasonable" and "not discriminatory" within a particular loan or product category, the bank said.

It also sought the lenders to disclose the quantum and reason for penal charges.

The instructions would come into effect from Jan. 1 and are not applicable to credit cards, external commercial borrowings, trade credits and structured obligations, it added.