RBI bats for borrowers, releases guidelines to prevent lenders from levying penal interest on loan defaults

• The determination of interest rates for credit facilities, as well as the conditions for resetting interest rates, will be closely regulated by the applicable regulatory instructions.
  
• Penal charges cannot be capitalized, which means that no further interest can be calculated on these charges.
  
• Whenever reminders for installment payments are sent to borrowers, the applicable penal charges must also be communicated to them, said RBI.
  

Banks and NBFCs cannot charge you a higher rate of interest or charge you an interest on late fees in case you default on your EMI payments.

To ensure fairness and openness in disclosing penal interest, the Reserve Bank of India (RBI) has issued several guidelines to Regulated Entities (REs) on Wednesday.

These new guidelines allow lending institutions to create their own board-approved policy for charging penal rates of interest in case of defaults or non-compliance by borrowers with the terms of their credit facilities.

However, the RBI has noticed that many REs are imposing penal rates of interest on top of the regular interest rates when borrowers default or fail to comply with the terms of their credit facilities.

The purpose of imposing penal interest or charges is primarily to encourage credit discipline among borrowers by using negative incentives and to provide fair compensation to the lender. It is not intended to be used as a way to increase revenue beyond the contracted interest rate.

However, it has been seen that there are varying practices among REs when it comes to charging penal interest or fees, which can result in customer complaints and disputes. The new guidelines intend to alter this practice.

EMI defaulters cannot be charged a penal interest

The determination of interest rates for credit facilities, as well as the conditions for resetting interest rates, will be closely regulated by the applicable regulatory instructions. REs are not permitted to introduce any extra components to the interest rate, as per the new guidelines.

“Banks and NBFCs can no longer charge penal interest on overdue payments from borrowers. So, for e.g. you had a loan at 16% interest. In case of default some banks and NBFCs, would charge you incremental penal interest on the overdue amounts (and sometimes on the principal), over and above the agreed interest rate,” says Aditya Kumar, co-founder & CEO, NIRO, a fintech platform that provides embedded credit solutions to consumer internet platforms. This is now prohibited.

Also, if a borrower defaults or fails to comply with significant terms and conditions of the loan agreement, any penalty that is charged should be considered as 'penal charges'. It should not be in the form of 'penal interest', which is added to the interest rate applied to the advances.

Penal charges cannot be capitalized, which means that no further interest can be calculated on these charges. However, this does not affect the standard procedures for compounding interest in the loan account.

“While banks and NBFCs are permitted to levy penal charges for late payments, these can no longer be capitalized. Let us say you have an EMI of ₹3,000 and a late payment fee of ₹500, you can not treat ₹3,500 as overdue and start charging interest on it,” says Kumar.

Clear communication of penal charges

REs must clearly communicate penal charges and the conditions under which they may be imposed to customers through the loan agreement and other important terms and conditions documents or Key Fact Statement (KFS), as applicable, RBI said in its new guidelines.

REs must also display this information on their website under the section on Interest Rates and Service Charges. Whenever reminders for installment payments are sent to borrowers, the applicable penal charges must also be communicated to them.

"The RBI Circular on penal charges represents a significant move towards greater disclosure and transparency on penal charges to customers. As a part of customer complaints, penal interest and hidden charges have been a significant area of concern for the customers and the regulator has taken cognizance of the same and come up with these guidelines,” says Vivek Iyer, partner and leader, financial services risk, Grant Thornton Bharat.

Iyer says that distinguishing penal charges from penal interest is a significant change in these guidelines. “We expect customers to have greater clarity on penal charges going forward,” he added.