[2:280] If there is one in misery, then (the creditor should allow) deferment till (his)ease, and that you forgo it as alms is much better for you, if you really know.
Legal Status of Late Penalty payments in Islam
Shaykh (Mufti) Muhammad ibn Adam al-Kawthari (HA)
Q: Monetary penalties on late payment: if a customer delays in paying, can we charge him for this (and specify it in the contract beforehand)?
In the name of Allah, Most Compassionate, Most Merciful,
According to Shariah, if a client is defaulting in payment due to poverty, then he must be given respite until he is in a position to pay. And to forgive him altogether is very virtuous.
Allah Most High says:
If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you, if ye only knew (Surah al-Baqarah, 280).
However, if the debtor is defaulting without any valid excuse (as is the general case), then the solution is not in charging him an extra amount as a penalty, as this will constitute Riba.
Imam al-Bayhaqi (Allah have mercy on him) reports the interpretation of Riba by the Companion Fudhala ibn Ubaid (Allah be pleased with him) in the following words:
Any lending arrangement which derives benefit is riba (Sunan al-Bayhaqi)
In light of the above and what the Fuqaha mention in their respective works, the majority of the contemporary scholars are of the view that to charge any amount on late payment will be regarded as Riba, thus unlawful (haram).
In the days of ignorance (jahiliyyah), people used to charge additional amounts from their debtors when they were not able to pay at the due date. They used to say:
Either you pay off the debt or you increase the payable amount
This was conclusively prohibited by the relevant verses of the Quran.
However, if this (charge) was a fixed payment in a way that at the time of making the agreement the client was given a choice between two prices, and he accepted one of them, then this will be permissible and not fall within the definition of Riba.
For example, a trader said to the client: If you pay me after one month, the price is five pounds, and if you pay after two months, it will be ten pounds. Now, if he chose one of the two options and the agreement took place on it, e.g. he said: I take the option of paying you ten pounds after two months, this will not be classed as Riba.
If, however, the contract was not finalized by deciding on one of the two options, e.g. the client said: I will see whether I can pay you in one or two months, (and as a consequence, five or ten pounds) then this will fall into the definition of Riba, thus Haram.
This has been clearly mentioned by Imam Tirmizi In his Sunan where he states under the Hadith narrated by Abu Hurairah (may Allah be pleased with him).
The Messenger of Allah (Sallallahu Alayhi Wasallam) forbade from contracting two transactions in one transaction (Sunan al-Tirmizi, 2/514).
Imam al-Tirmizi says:
Some scholars have said with regards to the meaning of this Hadith: Two transactions in one is, for example, when one says: I sell you this garment for ten if the payment is in cash, and for twenty if the payment is deferred, and they don't decide on any one of the two. However, if they depart by specifying one, then there is nothing wrong with that (ibid).
In view of the above, a fixed penalty on late payment will be considered Riba, thus Haram. However, if at the time of agreement, the seller fixed a specific price for the delay in payment, meaning he says: Due to the fact you will be paying late, the price is such and such, and this fixed price does not increase, if he defaults even more, then this would be permissible.
As far as the final part of your Questionis concerned, charging interest with the intention of giving it for charity is by no means permissible. Interest is unlawful, whether used for personal needs or given in charity.
However, contemporary scholars have mentioned with regards to Islamic Banks that if a client undertakes that in case he defaults in payment at the due date, he will pay a specified amount to a charitable fund maintained by the bank, it will be permissible.
This is regarded as a self-imposed penalty and a sort of vow, in order to put pressure on the debtor to pay promptly. Normally, such vows create a moral obligation and are not enforceable through courts.
It should also be insured here that no part of this amount shall form part of the income of the creditor, as that will constitute Riba. (See, Muhammad Taqi Usmani, Islamic Finance, P. 137).
In conclusion, fixing any penalty for late payment falls into the definition of Riba, thus unlawful, even if the intention is to give the amount in charity. However, if the debtor makes a promise, even contractual, of giving some amount to a charity, then this will be permissible.
And Allah knows best
Muhammad ibn Adam al-Kawthari, UK
Advice for Islamic Schools & Institutes
It is obvious that late fees and payments cause disruption to the finances of the institute and delay payments of Salaries etc. A Shariah compliant way to avoid the financial consequences of late payments for those who have no genuine excuse would be to enact two contracts, for example for an Islamic School charging £60 per student would present two contracts to the Parents as follows:
1 Parents who pay by the 21st of July will be charged £60.00 per child
2 Parents who pay after the 21st of July will be charged £70.00 per child
This method should be put to the Shura and relevant Scholars for approval.