Levying penal interest or charges is intended to guarantee that the lender is fairly compensated as well as to instill a sense of credit discipline in borrowers through disincentives.
Regulated Entities misuse penal interest
Penal interest and charges are not intended to be utilised to increase revenue over the agreed-upon interest rate, stated the RBI draft circular. Supervisory assessments have found that there are differences in how the REs apply penal interest and charges, which can cause client complaints and disputes.
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According to the RBI press release on Statement on Developmental and Regulatory Policies dated February 8, 2023, “The extant regulatory guidelines on levy of penal interest have been reviewed in the above context. It has been decided that any penalty for delay/default in servicing of the loan or any other non-compliance of material terms and conditions of loan contract by the borrower shall be in the form of ‘penal charges’ in a reasonable and transparent manner and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest being charged on the advances. Further, there shall be no capitalisation of penal charges (i.e., the same shall be recovered separately and shall not be added to the principal outstanding). However, in case of any deterioration in credit risk profile of the borrower, REs shall be free to alter the credit risk premium under extant guidelines on interest rate. Draft guidelines to the above effect shall be placed on RBI website shortly, for comments from stakeholders.”
Following an assessment of the procedures used by REs to impose penalties on loans, the following guidelines are made available to follow according to the RBI circular dated April 12, 2023.(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.
Note that the above instructions will not apply to credit cards which are covered under product specific directions.