Penal interest on loan defaults replaced by Penal Charges i.e, no further interest on such charges – RBI

Penal interest on loan defaults replaced by Penal Charges i.e, no further interest on such charges. RBI releases Draft Circular on Fair Lending Practice – Penal Charges in Loan Accounts

The Reserve Bank of India has released the Draft Circular on Fair Lending Practice – Penal Charges in Loan Accounts. Comments by the stakeholders on the ‘Draft Circular’ may be submitted by May 15, 2023.

The RBI has underlined that Penal interest/charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.

The following instructions have been proposed in the Draft Circular.

(i) Determination of interest rates on credit facilities, including conditions for reset of interest rates, will be strictly governed by the relevant regulatory instructions issued in this regard. REs shall not introduce any additional component to rate of interest.

(ii) Penalty, if charged, for default / non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances. There shall be no capitalisation of penal charges, i.e, no further interest computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account.

(iii) It needs to be recognised that the rate of interest on a loan includes appropriate credit risk premium reflecting the credit risk profile of the borrower. If the credit risk profile of the borrower undergoes change, REs will be free to alter credit risk premium as per the contracted terms and conditions, in terms of extant instructions.

(iv) The quantum of penal charges shall be proportional to the defaults/ non-compliance of material terms and conditions of loan contract beyond a threshold. This threshold is to be determined by the REs and shall not be discriminatory within a particular loan / product category.

(v) The penal charges in 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.

(vi) Penal charges and the conditions precedent therefor, shall be clearly disclosed by REs to the customers in the loan agreement and most important terms & conditions / Key Fact Statement (KFS) as applicable, in addition to being displayed on REs website under Interest rates and Service Charges.

(vii) Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges, shall also be communicated.

(viii) The REs shall ensure that there is a clearly laid down Board approved policy on penal charges or similar charges on loans, by whatever name called.

(ix) The operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examination by the RBI.

(x) These instructions shall come into effect from a date to be indicated in the final circular and REs may carry out appropriate revisions in their policy framework and ensure implementation from the effective date.

The above instructions shall not apply to Credit Cards which are covered under product specific directions.

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