Why the RBI has directed lenders not to levy penal interest on borrowers

Source: The post is based on the article “Why the RBI has directed lenders not to levy penal interest on borrowers”  published in Indian Express on 19th August 2023

What is the News?

The Reserve Bank of India (RBI) has issued a fresh set of guidelines for banks and other regulated entities (REs) on the imposition of penal charges on loan borrowers. 

These guidelines have been issued after it was reported that many banks 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. 

What do RBI guidelines say?

According to RBI guidelines, penalties charged for default on interest payments or non-compliance of material terms and conditions of loan contract by the borrower would now be accrued as ‘penal charges’ instead of ‘penal interest’.

To put it simply, lending entities would not be able to levy an ad-hoc additional penal rate of interest over and above the applicable rate of interest. 

For perspective about penal interest: say the borrower’s EMI payment for the month of April is Rs 1,000 at 10% interest rate.They default on making a timely EMI payment which subjects them to an additional interest payment of 24% per annum (or 2% per month) over and above the interest component (at 10% of principal amount) already payable that month.

RBI guidelines direct that ‘penal interest’ (at 2% p.a. in the example) be replaced with an ‘penal charge’, with no additional component to the rate of interest.

There shall be no capitalisation of penal charges, that is, it shall be levied separately and not be added to the principal outstanding amount.

The quantum of penal charges must be proportional to the defaults or non-compliance of material terms and conditions of a loan contract up to a certain threshold.

This is to be determined by the lending entities themselves and must not be discriminatory within a particular loan/product category.

What will be the impact of these guidelines on consumers?

Supervisory reviews have indicated divergent practices amongst the regulated entities(REs) with regard to levy of penal interest/charges leading to customer grievances and disputes.

Now, REs will have to disclose the quantum and reason for penal charges clearly to the customers in the loan agreement and most important terms and conditions/Key Fact Statement (KFS).

These will also be displayed on the website of REs under interest rates and service charges section.