What changed
RBI has prohibited the practice of levying penal interest as an add-on to the contracted interest rate. Instead, any penalty for non-compliance must be a one-time penal charge, not capitalized or compounded. Banks must now have a board-approved policy for such charges, disclose them clearly in loan agreements and KFS, and ensure they are reasonable and non-discriminatory. For existing loans, the switch must happen by the next review or within six months from January 1, 2024, whichever is earlier.
What it means for you
This is a significant shift from the current practice where many lenders used penal interest as a revenue tool. Banks can no longer layer penalties onto interest rates, which will reduce customer grievances and disputes. Lenders must redesign their penalty frameworks to be transparent and fair, ensuring charges are commensurate with the breach. The new rules apply to all fresh loans from January 1, 2024, and existing loans must be transitioned by July 1, 2024, or earlier.
What you must do
- Review and revise your board-approved policy on penal charges to align with the new flat charge structure, effective January 1, 2024.
- Update loan agreements, Key Fact Statements, and website disclosures to clearly state the quantum and reason for penal charges.
- Ensure IT systems are reconfigured to apply penal charges as flat fees, not as interest rate add-ons, and prevent capitalization.
- Communicate the new penal charges to borrowers in all default reminders and levy notifications.
- Plan the transition for existing loan accounts by the next review date or within six months from the effective date.
Who it affects
All Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks, excluding Payments Banks), All Primary (Urban) Co-operative Banks, All NBFCs (including HFCs), All India Financial Institutions (EXIM Bank, NABARD, NHB, SIDBI, NaBFID)
What is the key difference between penal interest and penal charges under the new rules?
Penal interest was added to the loan's interest rate and compounded, effectively increasing the cost of borrowing. Penal charges are a one-time flat fee for non-compliance, which cannot be capitalized or compounded. This prevents penalties from becoming a revenue tool.
Do these rules apply to existing loans?
Yes. For existing loans, the switch to the new penal charges regime must be done on the next review or renewal date, or within six months from January 1, 2024 (i.e., by July 1, 2024), whichever is earlier.
Are there any exemptions to these instructions?
Yes, the circular explicitly excludes Credit Cards, External Commercial Borrowings, Trade Credits, and Structured Obligations from these requirements.