Fair Lending Practices: New Guidelines on Penal Charges in Loan Accounts
The Reserve Bank has issued comprehensive guidelines to Regulated Entities (REs) to promote reasonableness and transparency in the disclosure of penal charges on loan accounts. These guidelines address the operational autonomy of lending institutions in formulating board-approved policies for levying penal rates of interest, ensuring that such charges are not used as revenue enhancement tools.
The primary intent behind levying penal interest or charges is to inculcate a sense of credit discipline among borrowers. However, supervisory reviews revealed divergent practices among REs, leading to customer grievances and disputes. To address these issues, the Reserve Bank has outlined specific instructions for REs to follow.
Firstly, any penalty charged for non-compliance with material terms and conditions of a loan contract by the borrower must be treated as ‘penal charges’ and not as ‘penal interest’ added to the applicable interest rate. Penal charges should not be capitalized, meaning no further interest should be computed on these charges. This does not affect the normal procedures for compounding interest in the loan account.
REs are prohibited from introducing any additional components to the rate of interest and must ensure full compliance with these guidelines. They must formulate a board-approved policy on penal charges or similar charges on loans, regardless of what they are called. The quantum of penal charges should be reasonable, commensurate with the non-compliance, and non-discriminatory within a particular loan or product category.
For loans sanctioned to individual borrowers for non-business purposes, the penal charges should not exceed those applicable to non-individual borrowers for similar non-compliance. The quantum and reason for penal charges must be clearly disclosed to customers in the loan agreement and the Key Fact Statement (KFS). These details should also be displayed on REs’ websites under Interest Rates and Service Charges.
Whenever reminders are sent to borrowers regarding non-compliance with material terms and conditions, the applicable penal charges must be communicated. Any instance of levying penal charges and the reasons for doing so should also be communicated to the borrowers.
These guidelines will come into effect from January 1, 2024. REs are required to make necessary revisions in their policy frameworks and ensure the implementation of these instructions for all new loans availed or renewed from this date. For existing loans, the switch to the new penal charges regime should be ensured at the next review or renewal date, or within six months from the effective date, whichever is earlier.
These instructions are issued under various sections of the Banking Regulation Act, 1949, the Reserve Bank of India Act, 1934, and the National Housing Bank Act, 1987, and will be updated in the relevant Master Directions and Circulars. However, they do not apply to credit cards, external commercial borrowings, trade credits, and structured obligations covered under specific product directions.
