2.11.1 Penal charges — implementation and worked examples

Why this page

RBI’s circular on Fair Lending Practice – Penal Charges in Loan Accounts, DOR.MCS.REC.28/01.01.001/2023-24, dated 18 August 2023, is one of the most-frequently-mis-implemented pieces of recent regulation. The rules look simple but the operational pattern in most legacy LMS systems was to wrap penalty as additional interest, which is exactly what the circular bans.

This page restates the rules cleanly and walks through four worked examples covering the common SME WC product scenarios.

Source

RBI Fair Lending Practice – Penal Charges in Loan Accounts, DOR.MCS.REC.28/01.01.001/2023-24, 18 August 2023.
Subsequent FAQs on Penal Charges issued by RBI.

The rules (verbatim shape)

Penal charges are separate from interest. Penalty for non-compliance with loan terms (delayed payment, breach of covenant, exceeding sanctioned limit, etc.) must be levied as penal charges, not as penal interest added to the rate.
No capitalisation. Penal charges cannot be added to the outstanding loan amount and earn further interest. They are a charge, not principal.
Board-approved policy required that defines the quantum and basis of penal charges and ensures non-discrimination across borrower classes within the same loan / product category.
Reasonable and proportionate. Penal charges should be commensurate with the non-compliance event; no penal levy can be excessive.
No discrimination based on retail / wholesale segment for the same loan / product class.
Full disclosure:
- In loan agreement and Key Fact Statement (KFS) at sanction.
- In most important terms and conditions (MITC) if separately maintained.
- On the lender’s website.
- In borrower communications at the time of penal-charge levy.
No re-pricing of interest rate as a substitute for penal charges.
Applies to all loans of REs sanctioned / renewed on or after 1 April 2024 (per the circular’s effective date as amended).

What this changed

The dominant pre-2024 practice was penal interest — adding 2 – 4% per annum to the loan’s interest rate during periods of default. This had two effects banned by the circular:

It compounded — penal interest in one period became part of the base on which next-period interest was computed.
It was opaque — the borrower’s running balance after default included penal interest indistinguishably from regular interest.

The new regime requires penal charges to be levied as a charge (one-time or per occurrence per the policy), recorded in a separate ledger entry, and never compounded.

Common penal-charge events in SME WC

Event	Typical board-approved charge basis
NACH / mandate bounce on due date	Flat fee per bounce, e.g., `₹500 – ₹1,500`
Late payment of EMI / dues	Flat fee per occurrence, e.g., `₹500 – ₹2,000` (or % of overdue amount, e.g., `2%` of overdue, with a cap)
Cheque return	Flat fee per occurrence
Exceeding sanctioned limit (WC line)	Charge based on overdrawn amount × days × board-approved rate
Non-submission of stock statement / periodic financials	Flat fee per occurrence, after notice
Insurance non-renewal (secured loans)	Flat fee + recovery of premium paid by lender

The exact rates are board-approved and disclosed in the KFS. The platform stores them as part of the product configuration (3.O Admin) and applies them via the LMS charge engine (3.J LMS).

Ledger treatment (the key shape)

For every penal charge event:

Dr. Borrower receivable — Penal charges  (separate GL account)
   Cr. Penal charges income — P&L         (separate GL account)

The borrower’s running outstanding has two distinct ledgers:

principal_outstanding
interest_accrued
charges_outstanding (a sub-ledger for fees + penal charges, never compounded into principal or interest)

Repayment allocation follows the board-approved waterfall, typically:

1. Penal charges
2. Other fees (late, bounce, etc., separately tracked)
3. Interest
4. Principal

Penal charges sit in their own bucket and reduce as repayments allocate to them. They never roll up into principal.

Worked Example 1 — NACH bounce on a revolving WC line draw

Scenario:

Borrower has a ₹40 lakh revolving WC line.
One drawdown of ₹15 lakh outstanding, with a ₹5 lakh repayment due on 2026-04-15.
NACH presents on due date; bounces (insufficient funds).
Board-approved bounce charge: ₹1,000 per occurrence (plus GST).

Day of bounce (2026-04-15):

Entry	Dr / Cr	Amount
Borrower receivable — Penal charges (bounce)	Dr	`₹1,000`
Penal charges income — P&L	Cr	`₹1,000`
Borrower receivable — GST on charges	Dr	`₹180`
GST output liability	Cr	`₹180`

Borrower’s running view:

Principal outstanding: ₹15 lakh (unchanged)
Interest accrued: continues per daily accrual
Charges outstanding (penal + GST): ₹1,180

Re-presentation on 2026-04-18 (per NACH re-presentation rules): succeeds for full ₹5 lakh.

Allocation per waterfall (penal first, then other fees, then interest, then principal):

Allocation	Amount
To penal charges + GST	`₹1,180`
To accrued interest (for `15 lakh × 21% × 3 days / 365`)	`~₹2,589`
To principal	`₹5,00,000 - 1,180 - 2,589 = ₹4,96,231`

The ₹1,000 penal charge did not become interest-bearing; it sat in its own ledger and was paid off first.

Worked Example 2 — Exceeding sanctioned limit (revolving WC line)

Scenario:

Borrower has a ₹40 lakh line.
Borrower’s drawdowns total ₹38 lakh outstanding. Borrower attempts a ₹5 lakh further drawdown.
Platform allows drawdown with override (manual approval). Actual drawn = ₹43 lakh, exceeding limit by ₹3 lakh.
Board-approved overdrawn charge: 2% per annum on overdrawn amount × actual days overdrawn.

Day 1 of overdrawn period:

The overdrawn period accrues daily. After 7 days:

Computation	Amount
Overdrawn × rate × days / 365	`300000 × 0.02 × 7 / 365 = ₹115` (approx)

This is charged daily to the borrower’s charges ledger:

Entry	Dr / Cr	Amount
Borrower receivable — Penal charges (limit)	Dr	`₹115`
Penal charges income — P&L	Cr	`₹115`
Plus GST

After 7 days borrower deposits ₹3 lakh to bring outstanding back within limit. The accumulated penal charges (~₹805 over the period) remain in the charges ledger until paid (allocated per the waterfall on the next repayment).

Note: this charge is separate from the regular interest that accrues on the ₹43 lakh outstanding at the contracted rate. The borrower pays both — interest on outstanding (at the agreed rate) plus penal charge for breach of limit covenant.

Worked Example 3 — Late payment on a term loan EMI

Scenario:

Borrower has a ₹50 lakh term loan, 24-month tenure, EMI ~₹2.45 lakh (at ~21%).
EMI for 2026-04-05 is missed. Borrower pays on 2026-04-15 (10 days late).
Board-approved late-payment charge: 2% of overdue EMI, with a minimum of ₹500 and a maximum of ₹5,000.

Day 10 — late charge levied:

Computation	Amount
`2%` of `₹2.45 lakh`	`₹4,900` (within the `₹500 – ₹5,000` range)

Entry	Dr / Cr	Amount
Borrower receivable — Penal charges (late)	Dr	`₹4,900`
Penal charges income — P&L	Cr	`₹4,900`

On payment, borrower pays ₹2.45 lakh EMI plus the ₹4,900 charge (with GST). Allocation:

Allocation	Amount
Penal late charge (+ GST)	`~₹5,782`
Interest for the late period (`50 lakh × 21% × 10 days / 365`)	`~₹2,877`
Reduction of EMI principal	balance

Note: the additional 10 days of regular interest accrual is charged separately at the contracted rate. It is not a penal interest; it is the natural accrual of regular interest on the outstanding principal during the delay. The ₹4,900 is the penal levy for the breach.

Worked Example 4 — Attempted foreclosure of a floating-rate MSME term loan

Scenario:

Borrower has a ₹50 lakh floating-rate term loan to an MSME (Udyam-registered).
After 9 months, borrower wants to foreclose.
Old practice would charge 4% foreclosure fee.

RBI rule: per the RBI circular on Levy of Foreclosure Charges / Pre-payment Penalty on Floating Rate Term Loans, DBOD.Dir.BC.110/13.03.00/2013-14, 7 May 2014 — foreclosure / pre-payment penalty is banned on floating-rate retail and MSME term loans by banks; the same expectation applies to NBFCs.

Correct treatment:

No foreclosure charge can be levied.
The borrower pays the outstanding principal + accrued interest up to the foreclosure date.
NOC issued; bureau updated; mandate cancelled.

Common breach (avoid): Some legacy LMS systems still levy foreclosure charges on floating-rate MSME loans by mis-categorising the loan as commercial-non-MSME. The platform’s charge engine must check the borrower’s MSME status before levying any foreclosure charge and block the levy for MSME borrowers on floating rate loans.

For fixed-rate MSME loans or non-MSME loans, foreclosure charges may be levied per the disclosed policy.

What to build in the platform

Separate GL account per charge type — bounce, late payment, limit-exceed, etc.
Separate borrower ledger for charges_outstanding; never compound into principal or interest.
Repayment waterfall enforced — penal first per board policy.
Board-approved charge configuration in admin module, versioned, audit-trailed.
MSME-status check before levying foreclosure / pre-payment charges on floating-rate loans.
KFS template auto-includes the current board-approved penal charge schedule.
Borrower communication at the time of penal-charge levy — SMS / WhatsApp / email per channel preference, explaining the charge.
Periodic review of penal-charge volumes per board policy — disproportionate penal-charge levy attracts regulator scrutiny.

Audit evidence

KFS issued and acknowledged showing the disclosed penal-charge schedule.
Charge ledger entries with timestamps.
Borrower communication at levy.
Board-approved penal-charge policy document with version history.
MIS showing penal-charge volumes by type and by product, for board review.

Common audit findings

Penal interest still being applied (legacy LMS), not penal charges. Critical.
Penal charges capitalised into principal. Critical.
Disclosure in KFS doesn’t match charges actually levied. Material.
Foreclosure charge on floating-rate MSME term loan. Material.
Same charge applied in retail and wholesale differently without justification. Material.

Sources

RBI Fair Lending Practice – Penal Charges in Loan Accounts, DOR.MCS.REC.28/01.01.001/2023-24, 18 August 2023.
RBI FAQs on Penal Charges (periodic).
RBI Levy of Foreclosure Charges / Pre-payment Penalty on Floating Rate Term Loans, DBOD.Dir.BC.110/13.03.00/2013-14, 7 May 2014.
NPCI NACH procedural guidelines on bounce treatment.