RBI stops Banks from compounding penal interest on loans, Check new guidelines

Under the new guidelines, penalties for non-compliance with the terms and conditions of a loan contract will be treated as “penal charges” and not as “penal interest”. This means that penalties cannot be added to the interest rate charged on the loan.

There will also be no capitalization of penal charges, which means that no further interest will be charged on the penalties. However, this does not affect the normal procedures for compounding interest in the loan account.

The RBI has also asked banks not to introduce any additional component to the interest rate and to ensure compliance with the new guidelines. Banks will need to formulate a board-approved policy on penal charges or similar charges on loans.

The new guidelines are applicable to all commercial banks, small finance banks (except payment banks), NBFCs including housing finance companies, and other financial institutions such as SIDBI and EXIM banks.

New Guidelines

• Banks can no longer treat penalties for non-compliance as “penal interest” that is added to the rate of interest charged on the advances. Instead, they must treat them as “penal charges”.
• There should be no capitalisation of penal charges, meaning no further interest computed on such charges.
• Banks should not introduce any additional component to the rate of interest.
• Banks need to formulate a board-approved policy on penal charges or similar charges on loans.
• The quantum of penal charges shall be reasonable and commensurate with the non-compliance of material terms and conditions of loan contract without being discriminatory within a particular loan product category.
• In case of loans sanctioned to individual borrowers, for purposes other than business, the penal charges should not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.
• Banks need to clearly disclose the quantum and reason for penal charges to the customers in the loan agreement and most important terms and conditions as applicable, in addition to being displayed on the banks’ website under Interest rates and Service Charges.
• Whenever reminders for non-compliance of material terms and conditions of loan are sent to borrowers, the applicable penal charges needs to be communicated. Banks should also communicate any instance of levy of penal charges and the reason.
• The RBI has asked banks to carry out appropriate revisions in their policy framework and ensure implementation of the instructions in respect of all the fresh loans availed or renewed from the effective date.
• In the case of existing loans, the switchover to new penal charges regime shall be ensured on next review or renewal date or six months from the effective date of this circular, whichever is earlier.

The RBI has taken these steps to ensure that penal charges are used as a tool to inculcate a sense of credit discipline and not as a revenue enhancement measure. The new norms will also help to improve transparency and fairness in the way that penal charges are levied.