The Reserve Bank of India (RBI) recently issued a draft circular on Fair Lending Practices. The draft circular has proposed to remove penal rates of interest, which are often charged by lenders over and above the applicable interest rates.

Experts say that the RBI’s draft fair lending practice guidelines will help maintain a balance between safeguarding borrowers’ and lenders’ interest.

“The fair lending practice guidelines issued by the RBI have managed to maintain a balance between safeguarding borrower and lender interests while cracking down on predatory policies. The guidelines bring greater transparency and improve the borrower’s trust in the lender. At the same time, the regulator has given enough freedom to the lender to draft and declare policies that are in the right spirit of levying penal charges for poor borrower behaviour,” says Gaurav Chopra, Founder & CEO of IndiaLends.

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The draft guidelines are currently open for comments from stakeholders till May 15. Following are the key points from the circular that borrowers should know:

1. The RBI has observed that many Regulated Entities (REs) use penal rates of interest, over and above the applicable interest rates, in case of defaults/non-compliance by the borrower with the terms on which credit facilities were sanctioned.

2. RBI says that the “intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender. Penal interest/charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.” However, “However, supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest/charges leading to customer grievances and disputes.”

3. The RBI has proposed that the determination of interest rates on credit facilities, including conditions for reset of interest rates, should be strictly governed by the relevant regulatory instructions issued in this regard. REs should not introduce any additional component to the rate of interest.

4. Further, the RBI says, “Penalty, if charged, for default/non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances.”

“There shall be no capitalisation of penal charges, i.e, no further interest computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account,” it adds.

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4. The RBI has stressed in the draft circular that the rate of interest on a loan includes an appropriate credit risk premium reflecting the credit risk profile of the borrower. “If the credit risk profile of the borrower undergoes change, REs will be free to alter credit risk premium as per the contracted terms and conditions, in terms of extant instructions.”

5. Further, the quantum of penal charges should be proportional to the defaults/ non-compliance of material terms and conditions of loan contracts beyond a threshold. This threshold will be determined by REs and it should not be discriminatory within a particular loan/product category.

6. If this draft circular comes into effect then the penal charges in case of loans sanctioned to individual borrowers, for purposes other than business, will not be higher than the penal charges applicable to non-individual borrowers.

7. The REs will have to communicate the applicable penal charges whenever the REs send reminders for payments of instalments to borrowers.

8. The above instructions will not apply in the case of credit cards.