Penal charges, not penal interest: the RBI rule that caps what lenders can pile on a defaulting borrower

On 18 August 2023 the Reserve Bank of India issued circular RBI/2023-24/53 (DoR.MCS.REC.28/01.01.001/2023-24), titled "Fair Lending Practice - Penal Charges in Loan Accounts". In 8 short operative clauses it changed how every bank, co-operative bank, NBFC and housing finance company may punish a borrower who misses an EMI or breaches a loan covenant. The headline rule is simple: a lender may levy a penal charge, but it may no longer load a penal rate of interest on top of the contracted rate, and it may never charge interest on that penalty.

For a borrower who has already slipped into default, and who may soon be reading a SARFAESI demand notice or a claim before the Debt Recovery Tribunal, this is one of the few RBI instruments that directly limits the size of the number the lender puts in front of them. This playbook sets out what the circular says, when it applies, how to audit a loan statement against it, and what the Telangana High Court said about it in March 2026.

The Statutory Position

The circular is not a statute, but it is issued under statutory power. Paragraph 4 of RBI/2023-24/53 states that the instructions are issued under sections 21, 35A and 56 of the Banking Regulation Act, 1949, sections 45JA, 45L and 45M of the Reserve Bank of India Act, 1934, and section 30A of the National Housing Bank Act, 1987. Section 21 is the RBI's power to control advances by banks; section 35A is its power to issue directions that banks are bound to comply with. That is why the petitioner before the Telangana High Court in March 2026 described the directions as "binding on banks".

Paragraph 2 of the circular records the RBI's reasoning in its own words: penal interest or charges are meant "to inculcate a sense of credit discipline" and "are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest". The RBI said its supervisory reviews had found "divergent practices" leading to "customer grievances and disputes".

The 8 operative clauses in paragraph 3 are summarised below.

Paragraph 5 carves out 4 product lines covered by their own directions: credit cards, external commercial borrowings, trade credits and structured obligations. A credit card late-payment fee therefore sits outside this circular.

The circular also amended the Master Direction on Interest Rate on Advances dated 3 March 2016. Its annex shows that paragraph 5 of that Master Direction, which had allowed banks a Board-approved policy "for charging penal interest on advances", was deleted. The old permission to charge penal interest no longer exists in the master text.

Who is covered

The addressee list on the 18 August 2023 circular covers 5 groups: all commercial banks (including small finance banks, local area banks and regional rural banks, but excluding payments banks), all primary (urban) co-operative banks, all NBFCs including HFCs, and the all-India financial institutions (EXIM Bank, NABARD, NHB, SIDBI and NaBFID).

Procedure Step by Step

The timeline

The original clause 3(viii) set 1 January 2024 as the effective date. On 29 December 2023 the RBI issued circular RBI/2023-24/102 (DoR.MCS.REC.61/01.01.001/2023-24), extending the timeline by 3 months after lenders sought clarifications and time to reconfigure systems.

The practical consequence: by 30 June 2024 every loan in scope, old or new, should have moved to the penal-charges regime. Any penal interest debited to a covered account after that date is open to challenge under clause 3(i).

How to audit your own loan account

1. Pull the full statement of account from the lender for the period from 1 April 2024 to date, with each debit separately itemised. Clause 3(vii) requires every levy of a penal charge, with its reason, to be communicated, so the lender should be able to identify each one.
2. Find the sanction letter and the KFS. Clause 3(vi) requires the quantum and reason for penal charges to appear in the loan agreement and in the most important terms and conditions or KFS. Note the exact wording.
3. Check the lender's website. The same clause requires display under "Interest rates and Service Charges". Save a dated copy of the page.
4. Look for a rate change on default. If the effective rate on the account rose by a fixed margin (for example, "plus 2% per annum") during a period of default after the switchover date, that is the pattern clause 3(i) prohibits.
5. Look for interest on penalty. If a penal charge was debited and interest was then calculated on a balance that included it, that is capitalisation, which clause 3(i) prohibits. Normal compounding on unpaid interest is still permitted, so separate the two items.
6. Compare with the non-individual rate. For a personal, home or vehicle loan (not for business), clause 3(v) caps your penal charge at the level the lender applies to non-individual borrowers for similar non-compliance. Ask for the Board-approved policy under clause 3(iii).
7. Write to the lender first. Under the Reserve Bank Integrated Ombudsman Scheme, 2021, as summarised by the Telangana High Court on 24 March 2026, a complaint does not lie unless the customer first complained in writing to the regulated entity and received an unsatisfactory reply, or no reply within 30 days.
8. Escalate to the RBI Ombudsman within one year of the lender's reply, or within one year and 30 days of the complaint where there is no reply, per the same summary of the scheme.
9. If enforcement has begun, raise the excess penal amounts in writing in response to the lender's demand, and before any tribunal hearing the dues claim. Keep your arithmetic in a table.

You can rebuild what your EMI and interest should have been using the personal loan EMI calculator or the home loan EMI calculator, then compare the result with the lender's statement.

Worked illustration: penal interest versus penal charge

The figures below are a hypothetical example to show the mechanics; they are not any lender's actual rates. Assume Rs 10,00,000 outstanding at a contracted 10% per annum, and one EMI of Rs 25,000 overdue for one month.

The key structural point is the base. A penal rate runs on the whole Rs 10,00,000, while the actual default is the Rs 25,000 EMI, so the penalty is 40 times the size of the breach in base terms. A penal charge has to be "commensurate with the non-compliance" under clause 3(iv).

Borrower Defences Available

The circular gives a defaulting borrower 6 specific lines of argument. None of them wipes out the principal or the contracted interest; they attack only the penalty layer.

Three cautions apply. First, the circular does not apply to credit cards, ECBs, trade credits and structured obligations, as paragraph 5 says. Second, a prepayment or foreclosure charge is a different item. In the Telangana High Court case discussed below, Canara Bank argued that the 18 August 2023 circular "relate[s] to penal charges for non-compliance of loan conditions and [is] not applicable to prepayment penalty". If your dispute concerns a prepayment penalty, test it against your sanction terms; the foreclosure calculator helps you size it. Third, the rule against capitalisation does not stop ordinary compounding of interest, as clause 3(i) states expressly.

On timing, the strongest claims concern debits made after 1 April 2024 on fresh loans, and after 30 June 2024 on all loans in scope. For older periods, the borrower is relying on whatever the contract and the pre-2024 guidance said.

Recent Tribunal/HC Position

The clearest recent judicial treatment Oquilia could verify is M/s Vijayakrishna Spices Private Limited v. Canara Bank Limited, Writ Petition No. 18933 of 2025, Telangana High Court, decided on 24 March 2026 by Justice Nagesh Bheemapaka (full text on Indian Kanoon).

The facts as recorded in the order. The petitioner, a spice exporter that had banked with Canara Bank for more than 2 decades, moved its working capital to State Bank of India and pre-closed the Canara Bank facility on 28 March 2024 by paying Rs 166,65,63,557. On 30 March 2024 the bank debited a 2% pre-payment penalty of Rs 3,33,31,272 plus GST of Rs 59,99,628.96, a total of Rs 3,93,30,900. It also withdrew interest concessions of Rs 13,55,156 on packing credit and Rs 70,056 on cash credit, and recovered Rs 57,82,581 described as a forex-rate concession.

The circular argument. The petitioner relied on the 18 August 2023 circular, arguing that clause 3(vi) requires disclosure of the quantum and reason for penal charges in the loan agreement and KFS, that clause 3(vii) requires the borrower to be told whenever a charge is levied, and that these directions under section 35A of the Banking Regulation Act are binding. It said the KFS did not disclose the quantum and no notice preceded the debit. The bank replied that its sanction letters dated 26 April 2018, 11 September 2019, 31 March 2021, 10 January 2022 and 28 March 2023 each stated the 2% pre-payment penalty, and that the circular did not apply to pre-payment penalties at all.

What the Ombudsman did. The petitioner complained to the RBI Ombudsman on 28 August 2024. After a personal hearing on 5 February 2025, the bank reversed the Rs 57,82,581 forex recovery with FD-rate interest at 6.25% (Rs 2,95,070) on 23 April 2025, because the sanction terms did not mention forex concessions. The complaint was closed on 28 April 2025 as resolved under Clause 14(9)(a) of the Reserve Bank Integrated Ombudsman Scheme, 2021. A second complaint dated 2 May 2025 was closed on 5 August 2025 as already dealt with.

What the High Court held. The Court dismissed the writ petition on 24 March 2026 without deciding whether the bank breached the circular. At paragraph 13 it said the contention "regarding violation of RBI Circular dated 18.08.2023" involves "examination of contractual disclosures, key fact statements and banking guidelines which again require factual adjudication" that "cannot be conclusively determined in writ proceedings based on affidavits". It also noted an arbitration clause in the Common Hypothecation Agreement dated 28 May 2018, and that the petitioner had not challenged the Ombudsman's 28 April 2025 order. Relief was left open "before the competent forum".

What borrowers should take from it. Four practical points follow from the order:

• Forum matters. A High Court writ under Article 226 is a poor vehicle for a fact-heavy dispute about what a KFS disclosed. The Court pointed the petitioner to a civil court or arbitration.
• Documents decide. The bank won the disclosure argument at the writ stage because 5 earlier sanction letters carried the 2% figure.
• The Ombudsman can deliver. The only money the borrower recovered, Rs 57,82,581 plus Rs 2,95,070 interest, came through the Ombudsman, on a charge the sanction letter did not mention.
• If you lose before the Ombudsman, challenge that order. The Court treated the failure to seek to set aside the 28 April 2025 order as a reason the writ could not be maintained.

The Oquilia Research Desk is not aware of a reported Supreme Court ruling interpreting the 18 August 2023 circular itself as at 30 October 2026, and readers should check the current position with a qualified advocate.

FAQ

Does the RBI cap penal charges at a specific rupee amount?

No. The 18 August 2023 circular sets no rupee or percentage cap. Clause 3(iv) requires the charge to be "reasonable and commensurate", clause 3(iii) requires a Board-approved policy, and clause 3(v) caps non-business individual loans at the level charged to non-individual borrowers for similar non-compliance.

From what date can I object to penal interest on my loan?

For fresh loans, from 1 April 2024. For existing loans, from the next review or renewal date on or after 1 April 2024, and in any case no later than 30 June 2024, under RBI circular RBI/2023-24/102 dated 29 December 2023.

Can the bank still compound interest on my unpaid EMIs?

Yes. Clause 3(i) states that the bar on capitalising penal charges "will not affect the normal procedures for compounding of interest in the loan account". What it cannot do is charge interest on the penal charge itself.

Does the rule apply to my credit card late fee?

No. Paragraph 5 of the circular excludes credit cards, external commercial borrowings, trade credits and structured obligations, which are covered by product-specific directions.

Is a foreclosure or prepayment charge a "penal charge"?

That is disputed. In Vijayakrishna Spices v. Canara Bank (Telangana High Court, 24 March 2026), the bank argued the circular does not apply to pre-payment penalty, and the Court declined to decide the point in a writ. Use the loan balance transfer calculator to weigh the cost before you switch lenders.

Where do I complain if my lender ignores the circular?

Write to the lender first. If it rejects the complaint or does not reply within 30 days, you may approach the RBI Ombudsman under the Reserve Bank Integrated Ombudsman Scheme, 2021, within one year of the reply (or one year and 30 days of your complaint if there was none), as summarised in the Telangana High Court's order of 24 March 2026.

Will disputing penal charges stop SARFAESI or DRT action?

Not by itself. The circular limits the penalty layer only; principal and contracted interest remain payable. Raise the excess in writing against the lender's demand, keep evidence under clauses 3(i) to 3(vii), and protect your credit score by paying undisputed EMIs. The primary texts are the 18 August 2023 circular and the 29 December 2023 extension on rbi.org.in.

This article explains published RBI instructions and a reported court order as at 30 October 2026. It is not legal advice. The Oquilia Research Desk does not practise law.