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Understanding the RBI Guidelines on Penal Charges in Loan Accounts

RBI/2023-24/53DoR.MCS.REC.28/01.01.001/2023-24 - August 18, 2023

The Reserve Bank of India (RBI) has issued updated guidelines regarding penal charges on loan accounts under the title "Fair Lending Practice - Penal Charges in Loan Accounts." This move aims to promote transparency and fairness in the lending process, while also ensuring that borrowers are treated equitably across all financial institutions. The guidelines are based on provisions of the Banking Regulation Act, 1949, the Reserve Bank of India Act, 1934, and the National Housing Bank Act, 1987.

Purpose of the Guidelines

The primary aim of these instructions is to ensure that regulated entities (REs), such as banks and financial institutions, follow clear and reasonable practices when it comes to charging penal interest on loans. Here's a summary of the key objectives:

1.      Reasonableness and Transparency: The RBI wants to ensure that penal interest is disclosed transparently and in a manner that is fair to borrowers.

2.      Operational Autonomy: Lending institutions are given the freedom to design their policies for penal charges, but they must do so within the framework of these guidelines.

3.      Customer Grievances: Over the years, it has been observed that some institutions have used penal charges to generate additional revenue, leading to disputes and customer dissatisfaction. The guidelines aim to    curb this practice.

4.      Disciplinary Purpose: Penal charges are intended to promote credit discipline, not to serve as a revenue-generating tool for lenders.

Key RBI Instructions

The RBI’s updated instructions focus on ensuring that penal charges are applied fairly, reasonably, and transparently. Below are the major points to note:

1.       Definition of Penal Charges:

·         Penal charges for non-compliance with loan terms must not be added to the interest rate as “penal interest.”

·         These charges must not be capitalized (i.e., no further interest will be calculated on these charges). However, regular interest compounding on the loan will continue as per standard practices.

2.       No Additional Components:

·        The guidelines stress that lending institutions should not add any extra components to the base rate of interest. Institutions must strictly adhere to the prescribed penal charges policy.

3.       Board-Approved Policy:

·        Every RE must have a board-approved policy on penal charges. This policy should clearly define what constitutes a penal charge, the reasons for it, and the applicable amount.

4.       Reasonable Charges:

·       Penal charges must be reasonable and proportionate to the non-compliance of the loan contract's material terms. They should not be excessive or discriminatory within any specific loan category.

5.       Uniformity for Individual Borrowers:

·       Penal charges for individual borrowers (for personal, non-business purposes) must not exceed those applicable to non-individual borrowers for similar defaults.

6.       Clear Disclosure:

·       The quantum of penal charges and the reasons for them must be clearly stated in the loan agreement and in the Key Fact Statement (KFS). Additionally, these charges must be made visible on the lender's website   under sections like "Interest Rates" and "Service Charges."

7.       Communication of Penal Charges:

·         When borrowers are reminded about non-compliance with loan terms, the applicable penal charges must be communicated. Any application of these charges must also be explained in detail to the borrower.

8.       Implementation Timeline:

·        These instructions will take effect from January 1, 2024. REs must revise their internal policies accordingly, and the new penal charges regime should be applied to all fresh loans or renewals from this date onward.

·       For existing loans, the new penal charges should be implemented at the next review, renewal, or by July 1, 2024 (whichever is earlier).

Exceptions to the Guidelines

It’s important to note that the new RBI guidelines do not apply to all types of loans. Specifically, Credit Cards, External Commercial Borrowings, Trade Credits, and Structured Obligations are excluded from these rules as they are covered by product-specific directions.

Conclusion

The RBI’s new guidelines on penal charges in loan accounts are designed to bring more clarity, transparency, and fairness to the lending process. By introducing these measures, the RBI aims to protect borrowers from unfair practices while promoting responsible credit behaviour. As these changes come into effect in early 2024, financial institutions will need to ensure they are compliant with the new rules, and borrowers should be mindful of how these changes may impact their loan terms and conditions.

If you have any questions or concerns regarding your loan agreement, it’s always advisable to consult with your financial institution or a legal expert to better understand how these new guidelines might affect your loan account.

Sadashiv B. Pimplaskar

Legal Advisor, MyRinBazaar