With loans, the compounding works in the reverse. If you miss an EMI installment, the overdue amount (which includes the principal) gets added to the principal. And you must pay interest on the overdue interest too. Interest on interest. Sounds like compounding, doesn’t it? Just that it is now working against you. After you default (until you regularize) you don’t just have to pay “regular interest”. You must pay Penal interest.
What Is Penal Interest? How and When Do Banks Charge Penal Interest?
As the name suggests, if you don’t make EMI payments on time, the bank charges you a penalty in the form of higher interest.
The banks charge penal interest in two ways.
- On the complete loan amount: If you do not pay your EMI on time, for instance, then the loan interest rate goes up from 12% p.a. to 15% p.a. until you regularize the loan account. In this case, the penal interest is 3% p.a. but it applies on the entire loan outstanding amount. Here is an example from SBI Home loan MITC. OR
- On the Overdue amount: And not on the entire outstanding amount. You miss an EMI of Rs 50,000. You will be charged penal interest on the overdue amount. For instance, ICICI Bank charges 24% p.a. or 2% per month on the overdue amount (and not the principal outstanding) for both personal and home loans. Hence, the interest rate is high, but it is charged on a lower amount. By the way, ICICI Bank uses the word “additional interest” for the penal interest. Continuing with the above example, you will be charged a penalty of 2% of 50,000 = Rs 1,000. If you miss next month’s EMI too, the penalty in the next month would go up to Rs 2,000 (2% X 1 lac). Total penalty of Rs 3,000. Here is an example of penal interest calculation from Aditya Birla Capital website.
The calculation can get complex once you start charging interest on unpaid penal interest too.
By the way, the penal interest is over and above the other charges for missing the payments. For instance, the bank would find out about the missed EMI when your cheque or ECS debit bounces. There are extra charges for such events too.
Note that skipping an EMI is not the only event that can trigger penal interest. Depending on the terms and conditions of your loan agreement, this can happen due to non-financial events and breach of covenants (non-submission of documents) but this is more likely in business loans.
I see merit in penalizing borrowers for not making timely payments. Such penalties nudge borrowers to stick with good credit behaviour. However, penal interest is the most opaque method of penalizing customers. Most borrowers would struggle to ascertain the exact penalty amount.
What Does the RBI Think about Penal Interest?
I reproduce an extract from RBI’s statement dated February 8, 2023.
Clearly, RBI is also not comfortable with the levy of penal interest, which it has found is excessive at times. More than the high penal interest, a bigger problem is that most borrowers have no idea about how these calculations work and that is a cause of grievance and disputes.
The more confusing the calculation, the more it works in the favour of banks or to the detriment of the borrowers. Credit cards are a classic example. The calculations are too complex for most borrowers to understand. Once you start capitalizing penal charges (add unpaid penal charges to the principal outstanding), the calculations can baffle you.
RBI wants to work with a simpler solution, that of penal charges. For instance, if you miss an EMI, you will be charged a penalty of, say, Rs 1,000. These are easier for borrowers to appreciate.
How to Calculate Penal Charges?
While the penal interest has problems, the penal interest tends to take care of the size of the loan. The penalty increases with the size of the loan or the EMI. To an extent, this is fine too as the amount of money at stake (the bank’s risk) is greater for bigger loans and the bank wants to be compensated for the risk taken.
Coming back to penal charges, would you charge the same nominal penalty for an EMI default of Rs 1 lac (loan amount of Rs 50 lacs) and EMI default of Rs 1,000 (loan amount: Rs 50,000)? Clearly not.
RBI has not yet clarified how to calculate penal charges, and we will have to wait for guidelines from the regulator. In any case, such micro-aspects are usually left to the discretion of the banks.
I expect that the bank would link the penal charges quantum of the loan outstanding or the default amount (EMI). An example could be 2% of overdue amount per month. Now, if you see, this is not much different from the penal interest of 2% per month on the overdue amount. However, the “Penal charge” is much more transparent and easier to understand compared to “penal interest”. There will be a separate entry for penal charge in your loan account statement too.
Plus, as per RBI statement, such penal charge can’t be added to the outstanding principal amount. Thus, the banks would figure out other ways to penalize you on “unpaid penal charges”. For instance, the penal charges can increase with the duration of overdue balance.