Islamic financial institutions have struggled with the question of whether or not charging a penalty for a late payment is considered a form of riba (interest) in Islam. Here’s my take on the matter…

The generous Quran in the Sura Al-Baqra Verses No: 278 – 280 says:

(2:278) O you who believe, fear Allah and give up what remains [due to you] of interest if you are in truth 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 verses and specifically verse 280, it’s clear that in the case of paying a debt, if the indebted can prove the presence of hardship then a penalty-free postponement should be afforded the indebted.
How often the indebted needs to prove the persistence of their financial hardship thereafter and what the criteria for this hardship should be is left to interpretation and should be agreed on at the outset of the arrangement.

It’s important to mention here that I believe the burden of proving the absence of hardship whenever a payment is late is on the indebted. Not the party which is owed the money. This is because, and this is the case in almost every law imaginable, whosoever is making a claim is the party that is burdened with proving it so. The party owed the money is not going to claim that the indebted is in hardship, the indebted will, so they must prove that this is, in fact, the case.

Charging a Penalty: Halal or Haram?

Now, what about charging a penalty? When is it permissible to charge a penalty and how is charging a penalty different from charging interest?

Starting our investigation with the Quran and Sunnah, there is nothing there that causes me to believe that charging a monetary penalty is not permissible in Islam. Furthermore, it simply seems impractical for businesses to function without having the option of charging monetary penalties for late payments.

Allah (SWT) in the generous Quran says: “We want ease for you and not hardship.”

Depriving businesses of the option of charging penalties to collect what is legitimately owed to them would cause serious hardship for these businesses and in some cases make their entire business unviable.
Here a question strongly suggests itself which is: how is charging a penalty for a late payment different from charging interest on an unpaid debt?

The main distinction is as follows:

Charging interest on debt is meant to add to profits, is charged by the lender with regularity and is charged without the need for an agreement to have been broken.

Whereas charging a penalty for a late payment is meant to motivate compliance with an agreement, it is not charged regularly and is only charged when an agreement is broken.

Here we see that the intention of the debt holder is at the core of the difference between penalties and interest charged on debt. If the intention of the debt holder when charging a penalty is to motivate the indebted to pay their debt, then what they’ve charged can be considered a penalty. However, if their intention from charging the penalty is to make a profit then what they are collecting is interest (Riba).

The role of intention in classifying an act in Islam is spelled out in the hadith reported to us by Umar bin Al-Khattab who said:

“I heard Allah's Messenger (ﷺ) saying, "The reward for a deed depends on the intentions behind it, and every person will be judged based on what they intended...”

A good sign that the intended purpose of a penalty as a means to motivate compliance is not being abused is if the revenue from collected penalties is a trivial amount of the business’s overall revenue. The larger the share that penalties constitute compared to overall business revenue, the more suspect these penalties become.

Some scholars have suggested that penalties should only cover the expenses of the business related to the customer’s late payment and the rest of the collected penalty should be donated to charity.

While I think this is an understandable position, in my estimation it is rather difficult to account for exactly how much a late payment actually ends up costing a business and accordingly how much the business is entitled to keep for itself and how much it must donate to charity.

So, this solution seems rather impractical for businesses to implement.

Others have attempted to limit the amount that can be charged as a penalty. Saying for instance that a penalty on a delinquent payment can only be $40 but not more. Still, others have attempted to limit the number of times a penalty can be assessed for instance saying it can only be assessed once a month but not more.

To me, these attempts at assigning a dollar amount to the permitted penalty or limiting its frequency to a certain number of times seem rather arbitrary and may cause more harm than good.

Although I agree that the size and frequency of a penalty should be limited to only what it takes to motivate customer compliance with their agreement, I think the party most able to determine how much an effective penalty needs to be for and how often it should be charged is the party that is trying to collect what is legitimately owed to them, as long as this adheres to their agreement with the customer.

Therefore, in my opinion, distinguishing between a penalty used to enforce compliance and charging a fee for the use of money (which is interest-bearing debt or riba) is one of those cases where the “I know it when I see it” approach can be used.

When a business is using penalties as a means to bolster their profits rather than a tool to enforce compliance I am arguing that you’ll know it when you see it.

As I mentioned, penalties are only charged when an agreement is broken, are used infrequently and contribute a small share to overall business revenue whereas interest-bearing debt does not require an agreement to be broken, can be considered a regular occurrence in terms of frequency and typically constitute a non-trivial share of overall business revenue.

Hopefully, this has helped clarify the distinction between charging interest on debt (which is forbidden in Islam) and monetary penalties for late payments.