RBI Issues Instructions on Penal Charges in Loan Account

The Reserve Bank of India (RBI) has come out with instructions pertaining to penalties applicable on violation of loan contracts.

Financial institutions are authorized to autonomously establish policies approved by their Board of Directors for the implementation of penalty interest rates. Several financial institutions impose penalty interest rates in conjunction with the applicable interest rates in cases where borrowers fail to adhere to the terms of their credit agreements. RBI has observed that there are differing practices among the Recognized Entities (REs) regarding the imposition of penal interest/charges. These discrepancies have led to customer complaints and disputes.

Thus, RBI has issued the instructions vide circular bearing reference number RBI/2023-24/53 DOR.MCS.REC.28/01.01.001/2023-24 dated August 18, 2023, regarding the evaluation of practices implemented by REs for imposing penal interest/charges on loans. These instructions will come into effect from January 1, 2024, and would apply to:

  1. Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks, excluding Payments Banks)
  2. Primary (Urban) Co-operative Banks All NBFCs (including HFCs) and
  3. India Financial Institutions (EXIM Bank, NABARD, NHB, SIDBI and NABFID)

The following are exempted from the purview of these instructions:

  1. Credit Cards
  2. External Commercial Borrowings
  3. Trade Credits and
  4. Structured Obligations that are covered under product-specific directions.

The details of the instructions are as follows:

  1. If the borrower violates the loan contract, any penalties imposed will be deemed “penal charges” and not “penal interest” which shall be added to the interest rate. No additional interest shall be calculated on such charges.
  2. The REs must stick to the set criteria and not add any additional elements to the interest rate.
  3. Responsible entities must create a Board-approved policy for penalties or charges on loans, regardless of the terminology used.
  4. The penalties for violating the terms and conditions of the loan must be reasonable and proportionate, without discrimination based on loan or product category. The penal charges in the 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 for similar non-compliance of material terms and conditions.
  5. The REs must adequately explain the amount and cause for penal charges in the loan agreement and relevant terms and conditions. This information shall also be displayed on the REs website under ‘Interest rates and Service Charges.’
  6. Whenever notifications regarding non-compliance with material terms and conditions of the loan are issued to borrowers, the corresponding penal charges will be communicated. Additionally, any imposition of penalty fees and the corresponding justification shall be duly communicated.
  7. REs can alter their policy framework and comply with instructions for new or renewed loans from the effective date. Existing loans will transfer to the new penal charges regime at the next review or renewal date or six months from the effective date of this circular.