Islamic financial institutions have struggled with whether or not charging a monetary penalty for a late payment is considered a form of interest in Islam. Here’s my answer …
The generous Quran in the Chapter Al-Baqra Verse No:278 – 280 says:
(2:278) O you who believe, fear Allah and give up what remains [due to you] of interest, if you should be believers.
(2:279) And if you do not, then be informed of a war [against you] from Allah and His Messenger. But if you repent, you may have your principal – [thus] you do no wrong, nor are you wronged.
(2:280) And if someone is in hardship, then [let there be] postponement until [a time of] ease. But if you give [from your right as] charity, then it is better for you, if you only knew.
From these three verses and specifically verse 280, it’s clear that in the case of repaying a loan, unless you can prove the absence of hardship on the borrower, no penalties can be charged for a late payment.
The burden of proving the absence of hardship whenever a payment is late doesn’t scale and isn’t compatible with the needs of a for-profit business. But this difficulty doesn’t matter in the case of lending because Islam isn’t concerned with making lending a viable business. Lending in Islam is done strictly as an act of charity.
When it comes to non-lending activities, Islam is (generally) interested in ensuring that these activities can be made into viable businesses and therefore the burden of proving the absence of hardship when charging a late penalty is dropped. A lessor may charge a lessee a penalty if their payments are late just as a utility company may charge a customer for a late payment on an electric bill.
While the title of my blog is practical Islamic finance it seems obligatory that any opinion I articulate must conform with the practical nature of things. If I owe money to someone, whether I’m charged a “penalty” or “interest” makes no difference to me. From this perspective, the function of interest and the function of a monetary penalty seem precisely identical.
However, from the perspective of the party that is owed money I do think there is a substantive difference between interest and penalties; Interest is meant to generate profits whereas penalties are meant to enforce compliance. Accordingly, any penalty that is collected and ends up adding to the profits (or equity) of the company is forbidden. Companies may use proceeds from penalties to cover expenses directly related to collecting these penalties but everything in excess of these expenses must be donated to charity. In this way we ensure penalties don’t become a source of profit for the company and remain distinguishable from interest.
Let’s summarize with a chart: