When was the last time you were hit with a late fee and thought, “Well, this seems fair”? Suppose you missed a loan payment or delayed submitting financial documents to your bank. In that case, you probably know the pain of penal interest—a little extra interest banks used to slap on for your financial missteps. But recently, the Reserve Bank of India (RBI) decided to shake things up by swapping penal interest with something new: penal charges.
While this may sound like a small change, it has left borrowers scratching their heads and reaching deeper into their wallets. Let's take a closer look at whether this move has really benefited all the stakeholders.
So, What Exactly Is Penal Interest?
Banks used to impose penal interest whenever borrowers violated the terms of their loan agreements—whether it was missing an equated monthly instalment (EMI), failing to submit financial statements, or overdrawing an account. This penal interest was an extra rate, added on top of the original loan interest. In essence, you’d be charged for being late—and the longer you took to pay, the more interest would pile up. It was like being charged interest on your interest!
The Big Shift: Penal Interest to Penal Charges
In August 2023, the RBI issued new guidelines (
Reserve Bank of India - Notifications (rbi.org.in) aimed at improving transparency and fairness in the banking system. Instead of penal interest, borrowers would now face penal charges—a fixed fee that wouldn’t accumulate and grow like interest. This sounded like good news, right? Well, not quite.
What Really Happened?
For many banks, "penal charges" turned out to be nothing more than penal interest in disguise. They simply slapped the word "charges" on it and continued business as usual. The only noticeable difference? Penal charges don’t get added to the principal amount, so you don’t end up paying compounding interest on the penalty.
But before you breathe a sigh of relief, here’s the catch: penal charges are now subject to GST—a whopping 18% tax that wasn’t there before.
The GST Sting
Imagine you were paying Rs1,000 in penal interest. Under the new system, you’d pay Rs1,000 as a penal charge. But thanks to GST, that now jumps to Rs1,180. So, borrowers who were already struggling now have an additional 18% to worry about—making the switch from penal interest to penal charges anything but a relief.
Banks are still winning
Banks are no longer allowed to capitalise penal charges, but they can still charge interest on overdue amounts like missed EMIs or unpaid loan balances. This means the financial burden keeps growing, even if the penal charges don’t directly compound.
While the RBI’s guidelines were designed to protect borrowers from unfair practices, the reality is that many banks have used the opportunity to make penalties more expensive, not less.
Where’s the cap?
One glaring issue with these new guidelines is the lack of a cap on how much banks can charge.
Ref clarifications/ FAQ issued in Jan 2024 . RBI leaves it up to the banks’ board-approved policies to set the rates; but with no upper limit, this has given private banks free rein to levy sky-high penalties.
Some banks have begun charging excessive penal fees for multiple violations of loan sanction terms. For example, a delay in submitting a stock statement may incur a 2% penalty, and a further 2% penalty may be charged for delaying the renewal application, resulting in a total penalty of 4%.
Take a look at some real examples:
- Meanwhile, some banks, like IDBI, even charge penal fees on the entire outstanding balance, not just the overdue amount.
As per extant guidelines, the lenders (REs) are responsible for ensuring the timely registration of charges with CERSAI, and they bear the consequences, including any penalties for delays. But IDBI penalises the borrowers with Rs1,000 per day for the delay on the Bank’s part in registration of the charge.
GST’s Applicability?
The applicability of GST on penal interest requires clarification, as historically, penal interest did not attract GST. Banks impose penal charges as a penalty for breaching specific terms and conditions, and these charges do not result in the providing of any goods or services. Therefore, whether GST should apply to penal charges remains uncertain and needs further clarification.
Is the Software Ready?
According to the new guidelines, penal charges must not be compounded, meaning they should not be added to the outstanding loan amount when calculating interest. However, if these penal charges are not recovered within 90 days, the borrower’s account must be classified as a non-performing asset (NPA). Implementing these changes will require updates to the bank's software systems. Any delay in making these modifications could lead to a surge in customer complaints.
What did RBI Want to Achieve?
To be fair, RBI had good intentions. The goal was to:
- Inculcate credit discipline among borrower
- Make lending practices more transparent and fairer
- Stop banks from using penalties as an extra revenue source
- Stop divergent practices amongst the REs about the levy of penal interest
- Make the penalties 'reasonable' and 'commensurate' with the borrower’s non-compliance
- Put an end to customer grievances and disputes in penal provisions.
But somewhere along the way, those intentions got lost in translation. The divergent practices among REs continue to stay with missing transparency.
Conclusion: RBI Guidelines Have Fallen Short of Their Intended Purpose
Despite RBI’s well-intentioned efforts to promote fairness and transparency by introducing penal charges, how banks have implemented these guidelines has largely missed the mark. Instead of reducing the financial burden on borrowers and fostering credit discipline, the shift from penal interest to penal charges has left borrowers facing higher costs, compounded by the addition of GST. The lack of a clear cap on penal charges and continued opaque practices among banks has further undermined the guidelines' objectives.
Rather than achieving the desired outcome of protecting borrowers and ensuring reasonable penalties, the current system feels more like a bitter pill than a fair deal. To realign the guidelines with their original purpose of fairness and customer protection, RBI may need to revisit these rules. Potential solutions could include capping penal charges, exempting them from GST, or mandating significant reductions in penalty amounts.
Going forward, it would also be beneficial for the regulator to seek public input on such impactful changes to ensure a more balanced and effective implementation.
(Chandramouli Mohan retired as a senior manager from a public sector bank after 38 years of service in various capacities in several places across the country. He has been an RTI and consumer activist after his retirement in March 2020.)