The Reserve Bank of India (RBI) has updated the rules that lenders must abide by when applying loan penalties. When a borrower delays a payment or violates the terms of the loan, many lenders now impose additional interest, known as penal interest. The RBI has proposed that fines be assessed as a fixed fee instead since it thinks that lenders may abuse this practise. These fines are intended to both compensate the lender for the additional labour needed in managing an insolvent borrower and to encourage borrowers to make on-time loan repayments. The RBI has found that different lenders implement penal interest in different ways, which leads to client complaints and conflicts.The proposed laws stipulate that fines must be handled fairly and openly and are not permitted to be increased to the primary amount outstanding. If a borrower’s credit risk profile changes, lenders may adjust the credit risk premium, which is the additional interest charged to account for the possibility of a borrower failing.
The Reserve Bank of India (RBI) has issued a circular on April 12, 2023, outlining new regulations for lenders to follow when imposing penalties on loans. The key points of the circular are as follows:
- Lenders should only charge penal charges and not penal interest on loans in the event of a borrower’s default or non-compliance with loan terms.
- The penal charges should be reasonable and transparent, and should not be used to increase revenue over the agreed-upon interest rate.
- Capitalisation of penal charges is not allowed, meaning no further interest will be calculated on such charges.
- The quantum of penal charges shall be proportional to the defaults or non-compliance of material terms and conditions of the loan contract beyond a threshold, which is determined by the RBI-regulated entities (REs) and shall not be discriminatory within a particular loan/product category.
- The penal charges and the conditions precedent shall be clearly disclosed to the customers in the loan agreement and the most important terms & conditions/Key Fact Statement (KFS), and shall be displayed on REs website under Interest rates and Service Charges.
- Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges shall also be communicated.
- REs shall ensure that there is a clearly laid down Board approved policy on penal charges or similar charges on loans.
- The operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examination by the RBI.
- 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.
It is important to note that these instructions do not apply to credit cards, which are covered under product-specific directions.
To sum up, the Reserve Bank of India (RBI) has released a draft of guidelines to regulate the charging of penal charges on loan accounts. The aim of these guidelines is to ensure that such charges are reasonable, transparent, and not levied as a compounding interest rate. The RBI has observed that Regulated Entities (REs) have been misusing penal interest and charges, leading to client complaints and disputes. To address this issue, the RBI has provided guidelines that require REs to determine interest rates on credit facilities in a particular manner, treat penalties as ‘penal charges’ and not as ‘penal interest’, disclose penal charges to customers, and have a clearly laid down policy on penal charges. These guidelines will take effect from a date that will be mentioned in the final circular, and REs are expected to revise their policy framework appropriately and ensure implementation from the effective date.
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