During the COVID-19 pandemic, many borrowers faced sudden income disruptions, leading governments and financial regulators to introduce loan deferment programs as part of broader relief measures. These deferments were intended to ease immediate financial pressure, but they also raised important questions about how to treat the interest that accrued during the payment holiday — particularly whether such deferred interest should be capitalized.
Capitalizing interest means adding the unpaid or accrued interest to the loan’s principal balance, effectively increasing the total amount owed. Once capitalized, the future interest is charged on this new, higher balance, resulting in what is often described as “interest on interest.” While this approach allows lenders to preserve the time value of money and maintain accounting consistency, it can significantly increase the borrower’s repayment burden over time.
The permissibility of charging interest on interest has long been a point of ethical and religious debate. In conventional finance, it is legally acceptable but must be disclosed clearly to borrowers. However, in Islamic finance, compounding interest — or riba al-riba — is not permissible. This distinction became particularly relevant during COVID-19, when deferral programs designed as relief measures risked contradicting the principle of fairness if they resulted in compounded debt.
Different countries approached this issue in varying ways. In Bahrain and other GCC nations, central banks required banks to defer payments without imposing additional interest or fees, ensuring that borrowers would not face capitalization of deferred interest. Some regulators allowed interest to continue accruing during the deferral period but prohibited it from being added to the principal balance. In India, the Reserve Bank initially permitted capitalization as part of its moratorium scheme, but this led to widespread debate. The matter reached the Supreme Court, which eventually ruled against charging “interest on interest” for certain categories of borrowers, recognizing the extraordinary financial stress caused by the pandemic.
In the United States and parts of Europe, lenders generally continued to accrue interest during the deferment period, and in many cases, capitalization occurred once repayments resumed. Borrowers often faced extended loan terms or adjusted payment schedules to accommodate the deferred amounts. In contrast, Malaysia and other countries operating under Islamic banking principles avoided capitalization by restructuring payment schedules to ensure compliance with Sharia law, thereby preventing compounded profit.
Across all jurisdictions, the importance of transparency and borrower protection emerged as a central theme. Regulators emphasized that any modification to loan terms — whether through capitalization, rescheduling, or tenure extension — must be clearly communicated to borrowers. Many lenders extended the loan period rather than increasing monthly payments, helping borrowers manage repayments without the burden of additional compounding.
The COVID-19 experience underscored the balance between financial prudence and social responsibility. While capitalization of interest can serve a functional purpose in normal economic conditions, its use during a crisis risks deepening debt burdens and undermining the intent of relief efforts. The prevailing regulatory and ethical consensus leaned toward compassion over compounding, ensuring that short-term relief did not translate into long-term hardship for already vulnerable borrowers.
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