What Is The Difference Between Compounding Of Interest And Penalty?

Every term related to loans is significant for borrowers because they determine how much amount has to be paid back, including interest. It is essential that there is clarity about the exact meaning related to these terms.

One of the most significant areas is compounding and while this compounding is good when an investment is being made, it can turn out to be a big hit when it comes to loans and borrowings.

Here are various angles related to compounding and what banks are allowed to do, with respect to these calculations:

Compounding

Compounding is a simple term that has huge implications for an investor and a borrower. It is nothing but the process where interest is calculated on a bigger base with the passage of time, as the previous interest is added to the original base. This is often used in the process of investing as a tool that will help build wealth for an investor. So, for example, if there is a sum of Rs 10,000 invested, earning 10%, then in the first year, it will earn Rs 1,000 (10% of Rs 10,000). The next year, the earning will be Rs 1,100 (10% of Rs 11,000 as the base, which is Rs 10,000 plus Rs 1,000 interest) and so on. The same working can turn out to be a big hit when it is applied on loans and interest calculations on the loan, as the amount to be paid can keep rising, even when some of it is being paid off.

Penalty And Interest

Interest is the rate that is calculated and paid on the borrowing of the individual. Thus, every loan or borrowing will have a specific rate that is attached to it. The rate can be floating or fixed, depending on the nature of the loan. The interest is, thus, calculated for the period that the borrower has used the money and this will come to an end when the entire loan is repaid. This is a basic part of every loan and it has to be paid by the borrower as part of the loan repayment process.

A penalty, on the other hand, is levied when the borrower is not able to meet the repayment conditions of the loan. This can be either a delay in the payment of an Equated Monthly Installment, or even missing out on the repayment for a specific period of time. This will become an extra levy for the borrower, but it will come into the picture only when there is a default or violation of the terms of the loan.

Compounding Or Not?

The Reserve Bank of India, in its recent guidelines that banks have to adopt from Jan. 1, 2024, has made a clear distinction between the manner in which the penalty and the interest can be levied on the loan.

If there is a penalty, then this has to be shown separately and it will be called a penalty or penal charges and not something else like penal interest. The most important thing is that there should not be compounding of the penalty, which means interest cannot be charged on the penalty. 

The interest process is separate and this is a part of the original loan and is a basic requirement of the loan. If there is some repayment that is missed out, then the interest will keep piling and it is possible that the bank would levy interest on the interest, as well as the principle that has not been repaid on time. Thus, there can be compounding of the interest payment, but there should not be compounding of the penalty.

This can result in a significant relief for the borrower and it is important for them to know this difference, so that they understand what the bank is actually charging them.

Arnav Pandya is founder at Moneyeduschool.