The Reserve Bank of India (RBI) on April 12, 2023 issued guidelines to regulated entities to ensure transparency in the disclosure of penal charges and interest rates in loan accounts. These guidelines are meant to promote fair lending practices and prevent these regulated entities from using penal interest and charges as revenue enhancement tools over and above the contracted rate of interest.
“Penal charges and interest are essentially negative incentives used by lenders to ensure credit discipline among borrowers and to ensure fair compensation for the lender. However, supervisory reviews have revealed that many regulated entities have been using divergent practices when it comes to charging penal interest and charges, leading to customer grievances and disputes,” RBI said in its draft circular.
To address these issues, RBI has now issued the following instructions for regulated entities to follow:
- 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. The regulated entities shall not introduce any additional component to the rate of interest.
- Penalty, if charged, for default/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 advances. There shall be no capitalisation of penal charges, i.e., no further interest will be computed on such charges. However, this will not affect the normal procedures for compounding interest in the loan account.
- It should 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, the regulated entities will be free to alter the credit risk premium as per the contracted terms and conditions, in terms of extant instructions.
- The quantum of penal charges shall be proportional to the defaults/non-compliance of material terms and conditions of the loan contract beyond a threshold. This threshold is to be determined by the regulated entities and shall not be discriminatory within a particular loan/product category.
- 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.
- Penal charges and the conditions precedent shall be clearly disclosed to the customers in the loan agreement. Also, the most important terms and conditions and/or key fact statement (KFS) as applicable, will have to be displayed on the website of the regulated entities under the interest rates and service charges section.
- Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges shall also be communicated.
- The regulated entities shall ensure that there is a clearly laid down Board-approved policy on penal charges or similar charges on loans, by whatever name called.
- The operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examination by the RBI.
- The above instructions shall not apply to credit cards that are covered under product-specific directions.
The RBI’s guidelines are meant to ensure that regulated entities follow fair lending practices when it comes to charging penal charges and interest on loans. These guidelines are intended to protect the interests of borrowers and promote transparency in lending practices. It is essential for regulated entities to comply with these guidelines and adopt a customer-centric approach to lending.
Also, customers must be made aware of the applicable penal charges and interest rates upfront, and there must be no ambiguity in the terms and conditions of the loan agreement.
By following these guidelines, RBI hopes that regulated entities are able to build trust with their customers and ensure a fair and transparent lending process.
