PENALTY UNDER LOAN CONTRACTS SHALL BE TREATED AS A ‘PENAL CHARGE’ AND NOT ‘PENAL INTEREST’

Introduction

The Reserve Bank of India (“RBI”) in exercise of its powers under orders 21, 35A and 56 of the Banking Regulation Act, 1949, sections 45JA, 45L and 45M of the Reserve Bank of India Act, 1934, and section 30A of the National Housing Bank Act, 1987 issued directions vide circular no. RBI/2023-24/53 DoR.MCS.REC.28/01.01.001/2023-24 dated August 18, 2023 (“Circular”)¹ for charging of penal interest/charges on loans/advances by the regulated entities (“RE(s)”).

The following are the key highlights of the Circular:

1. If there is a default by the borrower in the material terms and conditions of the loan contract the penalty so levied shall be treated as a ‘penal charge’ and not ‘penal interest’. There shall be no capitalisation of penal charges i.e., there shall be no interest computed on such penal charge.


2. There shall be a board approved policy on penal charges which shall be reasonable, non-discriminatory and in consonance with the non-compliance of the material terms of the loan contract.


3. The quantum and the reason for the penal charges shall be disclosed by the REs in the loan contract.


4. These directions shall come into effect from January 01, 2024.

Conclusion The intention of RBI for issuing these directions is twofold, to inculcate a sense of credit discipline amongst the borrowers and to prevent the REs from using such charges/interest rates as a tool for the enhancement of their revenue.