Interest is the consideration paid in return for money borrowed. Money is measurable and has purchasing value and it has gained unanimous acceptance as the most widely used form of consideration in return for certain goods and services, if not the only one. When a transaction is for the advancement of money itself, the consideration is the additional amount that a person pays to the lender along with the principal amount i.e. the amount of loan taken. This earning capacity of money over time is commonly referred to as the time value of money. Time value of money is earned in the form of interest.
Based on the agreement between the borrower and the lender, the interest may either be calculated as simple interest or compound interest. Simple interest denotes a fixed proportion of the principal amount which the borrower bears for a specified term. Compound interest, on the other hand, is paid on the principal plus the amount of interest already accrued. Simple interest is, however, less common and it is generally compounded interest that forms a part of a lending transaction. Apart from compounded interest, when a person defaults in loan repayments, penal / default interest is usually available for the benefit of the lender. This becomes applicable for the period during which the loan dues remain unpaid. This is a percentage that is generally prescribed by agreement.
The Supreme Court of India in Shew Kissen Bhattar vs.
The Commissioner of Income Tax Calcutta observed that: ‘on failure of the borrower to pay in accordance with the terms of the contract he is liable to pay compound interest. In other words, if he fails to pay interest in accordance with the contract, he is liable to pay interest on interest. To put it differently, when the interest payable is not paid, the same becomes a part of the principal and thereafter interest has to be paid not only on the original principal but also on that part of the interest which had become a part of the principal.’
Basis the above, a question arises as to whether the default / penal interest may be compounded and charged on the borrower.
The Supreme Court of India in Central Bank of India vs. Ravindra and Ors. held that:
‘’penal interest’ has to be distinguished from ‘interest’. Penal interest is an extraordinary liability incurred by a debtor on account of his being a wrong-doer by having committed the wrong of not making the payment when it should have been made, in favour of the person wronged and it is neither related with nor limited to the damages suffered. Thus, while liability to pay interest is founded on the doctrine of compensation, penal interest a penalty founded on the doctrine of penal action. Penal interest can be charged only once for the period of default and therefore cannot be permitted to be capitalized.’
‘Though interest can be capitalised on the analogy that the interest falling due on the accrued date and remaining unpaid, partakes the character of amount advanced on that date, yet penal interest, which is charged by way of penalty for non-payment, cannot be capitalised. Further interest, i.e. interest on interest, whether simple, compound or penal, cannot be claimed on the amount of penal interest. Penal interest cannot be capitalised. It will be opposed to public policy.’
Basis the above decision by the apex court, it becomes abundantly clear that the doctrine of penal action entitles a lender to charge penal interest without capitalizing such amount, and without charging any additional interest on the unpaid amounts of penal interest.
  89 ITR 61(SC) at paragraph 6.
 AIR 2001 SC 3095 at paragraph 37 and paragraph 54; See also Punjab National Bank v. Narain Dass and Ors. AIR 2003 HP 69.
By Dhananjai Charan, Associate Juris Corp