MUMBAI: India’s central bank on Friday forbid banks and other lenders from charging penal interest from borrowers for not complying with the contractual terms and conditions of a loan to ensure fair lending practices and protect the interest of consumers.

Penalty, if charged, should be treated as “penal charges” and not be levied as “penal interest” on the existing rate charged on loan, the Reserve Bank of India (RBI) said in a notification.

The RBI observed that many lenders charge penal rates over and above the applicable interest rate on loans in case of defaults that breach the terms of credit facilities.

The intent of levying a penal charge is “essentially to inculcate a sense of credit discipline” and not as a revenue enhancing tool, the RBI said.

Lenders should not introduce any additional component to the rate of interest and ensure compliance to these guidelines in “both letter and spirit,” the bank added.

The RBI also asked the banks to formulate a board-approved policy on penal charges or similar levies on loans. Further, the quantum of penal charges should be “reasonable” and “not discriminatory” within a particular loan or product category, the bank said.

Indian central bank likely sold dollars to keep rupee from record low

It also sought the lenders to disclose the quantum and reason for penal charges.

The instructions would come into effect from Jan. 1 and are not applicable to credit cards, external commercial borrowings, trade credits and structured obligations, it added.