It is unlawful to stipulate any condition that entails the debtor to pay a penalty in case of default as this constitutes Riba (unjust addition to a loan).

This prohibited practice was done by the Arabs in the pre-Islamic period, who would offer the debtor to settle now or pay an additional amount for an extension of credit. For further reading, you can look at International Islamic Fiqh Academy resolution 51 no.6 [1: 193].

However, there are some technicalities stated that do allow for penalties to be made, but we won’t go there for now.