New RBI Rules about Loan Penalty and Wider Choice to Borrowers When Interest Rates Rise

RBI The Reserve Bank has come out with two separate circulars in the middle of August 2023. First about levy of penal interest and the second about the reset of interest rate in retail floating rate loans. We discussed both these topics when the RBI broached these topics for the first time.

The RBI has now come out with the final guidelines in this regard. In this post, let’s find out what RBI has changed.

Penal Interest Gives Way to Penal Charge

When you do not comply with any terms and conditions of your loan, the banks charge a penalty. This is to discourage you from breaching any contractual terms. Fair enough.

There are two broad ways to charge a penalty.

Penal charge: A flat charge or linked to the outstanding loan amount
Penal interest: Penalize borrower by increasing the loan interest rate

While the central bank has acknowledged that levying penal interest/penal charge is essential to inculcate credit discipline among borrowers, it also noted that the banks must not use these penalties for revenue enhancement.

The RBI has observed that levy of penal interest has caused many customer grievances and disputes. Hence, the Reserve Bank has done away with penal interest.

#1 No Penal Interest. Only Penal Charge

Under penal interest, in case of any breach of terms and conditions, the bank would simply increase the loan interest rate. By say 2% or 3% or any other number. So, your loan interest rate would suddenly go up from 9% to 12% p.a.

There were 2 problems with this approach.

If the interest rate goes up quietly, the borrower may not even notice it if the EMI remains constant. If the borrower is not informed about the breach, he/she may not try to resolve it. Thus, can continue to pay a high rate of interest for even a minor breach of loan terms. Seems unfair?
For a big loan amount, this quantum of penalty (due to penal interest) may be disproportionately large.

The borrower is more likely to notice a penalty in the form of an explicit penal charge. A penal charge can be a fixed amount or a percentage of the outstanding loan amount.

#2 No Capitalization of Penal Charge

The banks can’t charge interest on unpaid penal charges. While the banks can levy a further penalty for not alleviating the breach of terms and conditions or not paying the penal charge, they can’t charge interest on unpaid penal charge.

#3 Other Rules about Penal Charge

The quantum of penal charges should be reasonable and commensurate with the level of non-compliance.
The quantum of penal charges should be similar (not discriminatory) across borrowers within a particular loan/product category.
For a similar non-compliance, the penal charge for a retail loan should not be higher than loans to non-individuals. Non-individuals (businesses) tend to be more alert about such costs while individuals are not. RBI expects that non-individuals would negotiate with banks to control such penal charges and the benefit would pass on to the retail borrowers.
The details about penal charges (quantum and reason) shall be clearly disclosed to the borrowers in the loan agreement and MITC (Most important terms and conditions) and KFS (Key Fact Statement). Such information must also be displayed on the lender website under Interest Rate and Service Charges.
When any reminder for non-compliance is sent to the borrower, the applicable penal charges must also be communicated.
In addition, whenever a penal charge is levied, the bank must inform the customer about the charge and the reason.
These rules come into effect from January 1, 2024. Even for existing loans, the bank must switch to penal charges (in place of penal interest) at the time of next review/renewal or 6 months from the date of the notification, whichever is earlier.

#4 No Negative Amortization

You start with a certain rate of interest. A portion of EMI goes to cover interest and the remainder towards principal repayment. Over the next few months and years, the interest rates start rising. The bank keeps the EMI constant and increases the tenure. Clearly, a bigger portion of EMI goes towards interest payment (than at the start of the loan).

You may reach a point when the EMI does not even cover the interest. In which case, the unpaid interest will keep getting added to the loan. In other words, the loan amount will not come down but go up every month.

I am not sure if the banks show such patience with retail investors. As I understand, if even the interest is not covered, then the account will become sub-standard and eventually NPA. In any case, the RBI has explicitly disallowed negative amortization.

Think RBI is coming around from the point of view of “penal interest”, where a sudden rise in interest rate, due to even a technical breach, can cause a situation where the EMI does not even cover interest.

Say, the loan outstanding is Rs 50 lacs. 20 years. 9% p.a. The EMI wis Rs 44,986.

If the loan interest rate jumps to 12% p.a. (because of penal interest or simply due to rise in interest rates), the interest for the month would be Rs 50,000 (Rs 50 lacs X 12%/12). The EMI does not even cover the interest. No longer allowed even for a few months. The bank must increase the EMI to at least Rs 50,000 to avoid negative amortization.

This is a good rule since the borrowers notice the increase in EMI and may want to look into the reason for such an increase.

#5 Credit Cards Still outside the Ambit

All the above rules about penal charges and penal interest rates don’t apply to credit cards.

Why? I don’t know. If you know the reason, please let me know in the comments section.

Reset of Interest Rates in Floating Rate Loans

We discussed in this post how keeping EMIs constant in the wake of rising interest rates can cause extreme negative surprises. Loan mathematics is quite objective but difficult to appreciate. Not everyone understands how small interest change can impact loan tenure (if the EMIs are kept constant).

Any increase in the EMI or loan tenure or both on account of an increase in loan interest rate must be communicated to the borrower immediately through appropriate channels. This will help borrowers understand the impact easily.
At the time of reset of interest rate, the banks shall provide the borrowers with an option to switch to a fixed interest rate loan. This is interesting. Currently, fixed rate home loans are not common. Let’s see what banks do and offer.
In case of an increase in the loan interest rate, the borrowers shall be given a choice to increase EMI, increase tenure or both.
The borrowers shall also have an option to prepay the loan (in part or full) at any point during the loan tenure.
All charges for switching from floating rate to fixed rate or any other charges for exercising any of the above options shall be transparently disclosed in the sanction letter and at the time of revision of such charges.
No negative amortization (similar as we discussed above)
The banks must share/make accessible a quarterly statement which must state the principal and interest recovered till date, EMI amount, number of EMIs left, and loan interest rate (Annual Percentage Rate or APR). The banks must ensure that the statement is easy to read and understand.
The banks must ensure that these rules apply to all new and existing loans by December 31, 2023. All the borrowers must be intimated about these options available to them.

Both the decisions (the removal of penal interest and a wider choice for customers at the time of increase in loan interest rate) are favourable and would lead to more informed borrowers.

What do you think of these moves by the Reserve Bank of India?