RBI Sets Guidelines on Penal Charges, Prohibits Additional Interest on Defaults

Under the newly released guidelines, lenders are mandated to label penalties for loan defaults as 'penal charges' rather than 'penal interest.'

In a significant move aimed at safeguarding borrowers’ interests, the Reserve Bank of India (RBI) has issued new guidelines for lenders regarding penal charges imposed on defaulting borrowers. Effective from January 1, 2024, these directives prohibit the computation of further interest on such charges, thereby relieving borrowers from undue financial burden.

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Under the newly released guidelines, lenders are mandated to label penalties for loan defaults as ‘penal charges’ rather than ‘penal interest.’ The RBI’s emphasis on reasonable and fair charges proportional to the non-compliance of loan agreements ensures that borrowers are not subject to discriminatory practices within specific loan categories. This move comes as the RBI identified that several regulated entities, including banks, small finance banks, and regional rural banks, were imposing excessive penal rates of interest for non-compliance with credit terms.

A key aspect of these guidelines is the prohibition of capitalization of penal charges, meaning no additional interest will be calculated on such charges. However, standard procedures for interest compounding in loan accounts will remain unaffected. The RBI further instructed lenders not to introduce any supplementary elements to the interest rate and to adhere strictly to these guidelines.

For loans extended to individual borrowers for non-business purposes, penal charges cannot surpass those applied to non-individual borrowers facing similar non-compliance situations. The guidelines also stipulate the transparent disclosure of the amount and rationale for penal charges within loan agreements and other essential documents, as well as on lenders’ websites.

Lenders are required to communicate applicable penal charges when sending reminders to borrowers for non-compliance. Additionally, the reasons behind any levied charges must be clearly communicated. Existing loans will transition to the new penal charges regime during the next review or renewal date, or within six months from the circular’s effective date.

The guidelines, however, do not extend to credit cards, external commercial borrowings, trade credits, and structured obligations covered under product-specific directions. The RBI’s proactive approach to regulating penal charges seeks to foster a more equitable lending environment, relieving borrowers from excessive financial burdens arising from defaults or non-compliance with loan contracts. This development underscores the central bank’s commitment to ensuring fair lending practices and bolstering consumer protection in the financial sector.

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