NB Explains | HUGE! Banks can't levy penal interest on loans now; Check RBI's latest guidelines for banks, NBFCs

New Delhi, Aug 18: The Reserve Bank of India (RBI) has issued instructions for penal charges in loan accounts to ensure transparency in the disclosure of penal charges and interest rates in loan accounts. The guidelines with respect to penal charges in loan accounts will be effective from January 1, 2024.

This came against the backdrop of concerns over the practice of banks and non-banking financial companies (NBFCs) using penal interest as a revenue enhancement tool.

Now, the lenders would be able to levy only “reasonable" penal charges in case of default in repayment of loans.

RBI directs banks NBFCs not to levy penal interest on borrowers

"Under the extant guidelines, lending institutions have the operational autonomy to formulate Board approved policy for levy of penal rates of interest," RBI said in a notification on Fair Lending Practice - Penal Charges in Loan Accounts, the central bank said.

Further, it added, "It has been observed that many Regulated Entities (REs) use penal rates of interest, over and above the applicable interest rates, in case of defaults / 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 central bank said.

It added that 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".

#RBI says banks and other lenders cannot charge penal interest for non-compliance.
— Markets Today (@marketsday) August 18, 2023

The RBI also said the quantum of penal charges “shall be reasonable and commensurate with the noncompliance" of material terms and conditions of loan contract without being discriminatory within a particular loan/product category.

Also, there shall be no capitalisation of penal charges — no further interest computed on such charges. However, the instructions will not apply to credit cards, external commercial borrowings, trade credits and structured obligations which are covered under product-specific directions, the RBI said.

However, supervisory reviews have indicated divergent practices amongst the entities regulated by entities with regard to levy of penal interest/charges leading to customer grievances and disputes, it said, while issuing the modified norms.