Lenders can’t compound penal interest, says RBI
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Lenders can’t compound penal interest, says RBI

The Reserve Bank of India (RBI) has taken a significant step for fairness and transparency in disclosing penal charges.

Instead of ‘interest,’ penalties will now be considered a ‘charge’ and not compounded further.

This change won’t affect regular compounding of interest on loans. Regulated entities (RE) won’t add additional interest to penal charges.

Many REs impose penal rates alongside interest for defaults or non-compliance.

RBI’s circular offers guidelines for lenders based on a review of penal interest practices.

Penalties for borrower non-compliance will be termed ‘penal charges,’ not added to interest rates. This move aims to ensure penalties promote credit discipline.

Lenders must formulate board-approved policies on such charges without extra interest components. Penal charges must be reasonable and disclosed clearly in loan agreements and on websites.

Instructions are effective from January 1. New loans must follow them immediately, while existing loans switch over on review or within six months.

This shift will impact banks’ net interest margins, treating penalties separately from interest income.

The impact varies among banks based on past practices. While margins may be affected, fee income could rise, depending on charge structuring.

Advantages:

  1. Fair Treatment: The change ensures that penalties are fair and clear for borrowers.
  1. Clear Penalties: Penalties won’t add extra interest, making charges easier to understand.
  1. Helps Borrowers: Encourages better borrowing behavior, benefiting borrowers.
  1. Simple Rules: RBI’s guidelines give lenders clear instructions for consistent practices.
  1. Fair Charges: Penalties must be reasonable and disclosed upfront.
  1. More Accountability: Lenders must clearly communicate penalties, increasing accountability.

Disadvantages:

  1. Profit Impact: Banks might earn less as penalties aren’t counted as interest.
  1. Confusing Change: Changing existing loans might be complex and cause confusion.
  1. Unknown Effects: It’s unsure how much banks will be affected, as it varies.
  1. More Fees: Fees could increase as penalties are separate now.
  1. Possible Confusion: Borrowers might struggle to tell penalties from regular interest.
  1. Hard Implementation: Making all lenders follow this might be tough.

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