The Reserve Bank of India (RBI) has directed lenders to levy a penalty for default by borrowers as ‘penal charges’ and not as ‘penal interest’. In its guidelines on ‘Penal Charges in Loan Accounts under the Fair Lending Practice’, the central bank said that the quantum of penal charges should be ‘reasonable’ and ‘commensurate with the non-compliance of loan contract’ without being discriminatory within a particular loan/ product category.

What banks use to do

Banks used to say in case of defaults / non-compliance by the borrower with the terms on which credit facilities were sanctioned., they will increase the interest rate by 1%.

How will penal charges be fixed?

As per the central bank circular issued on August 18, penal charges can be fixed fees or a percentage of the balance outstanding but can’t see interest on interest).

When will this new rule come into effect?

These instructions shall come into effect from January 1, 2024. REs may carry out appropriate revisions in their policy framework and ensure implementation of the instructions in respect of all the fresh loans availed/ renewed from the effective date. In the case of existing loans, the switchover to the new penal charges regime shall be ensured on the next review or renewal date or six months from the effective date of this circular, whichever is earlier.

These instructions shall, however, not apply to Credit Cards, External Commercial Borrowings, Trade Credits, and Structured Obligations which are covered under product-specific directions, the central bank said.

RBI guidelines for banks, NBFCs penal interest loans: Key Takeaways

Banks are permitted to apply penal charges; however, these charges must not manifest as penal interest added onto the interest rate imposed on advances.

The imposed penal charges should remain reasonable and proportionate, aligning with the nature and scope of the default.

The accumulation of interest on these penal charges is prohibited

For loans granted to individual borrowers for non-business purposes, the penal charges should not surpass those applicable to non-individual borrowers.

Furthermore, as per the RBI guidelines, banks are obligated to transparently reveal the amount and rationale behind any imposed penal charges within the loan agreement. This disclosure should be presented in a straightforward manner and prominently featured within the agreement.

Additionally, the bank is required to exhibit the critical terms and conditions of the loan, encompassing the penal charges, on its website’s “Interest Rates and Service Charges” section.

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