The Difference between Islamic & Interest-Based Finance
  • Tue, 04/07/2015
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The Purpose of Finance

Finance aims to facilitate economic transactions and real economic activity. Real activity refers to transactions that directly involve economic production or consumption. Finance becomes necessary when there are insufficient funds to complete the requisite transactions. In these circumstances, finance adds value to the economy, since it permits beneficial real activity to take place that would otherwise not take place.

Islamic Finance

In Islam, all aspects of finance are directly linked to real activity. Islamic financial instruments are inseparable form real activity, like cost-plus deferred payment (bay` ājil), advance payment of goods (salam), lease agreements (ijārah), joint ventures (mushārakah), and profit sharing based on various contributions of capital and expertise (mudārabah).

This conforms to the true purpose of finance that we mentioned above. Since finance serves to facilitate real economic activity, Islamic financial instruments are always connected to sales and other real commercial transactions. Therefore, in Islamic law there are never purely financial or “paper” transactions concerned only with monetary gain, since that is contrary to the nature of finance and its economic function.

Interest-Based Finance

The returns on interest-based finance are detached from economic activity. Profits do not stem from any real production. It is possible for a loan to provide returns to the lender that are not connected with any economic activity that adds value to the economy. Debt growth takes place independently of the real economic output growth rate. Consequently, the debt rate grows faster than real economic growth until debtors are unable to pay their debts. The interest on this enormous debt continues to drain the economy and place a heavy burden on income.

For example, according to United Nations statistics, some of the poorest developing countries pay interest on their debts in excess of 70 per cent of their export income, and that export income is what provides those countries with their most important source of hard currency. This means that instead of finance acting as a catalyst for increased income, it becomes a burden upon it, and instead of it being a servant of economic activity, economic activity becomes a servant of finance.

The return on financial investments were originally assumed to come from the added value that they contributed by facilitating real economic activity, but with uncontrolled debt growth, this return becomes much larger than its value-added contribution, and this is what makes finance a negative factor in economic growth, rather than be a positive one.

The Cancer of Indebtedness

Some Western writers have likened the effect interest has on the economy to cancer in the way its excessive growth destroys living tissue. Interest causes debt to grow in disproportion to economic growth, just like cancer is caused by abnormal cell growth. In the absence of growth constraints, debt outpaces economic growth similar to the way cancer in the body outpaces normal cell growth. And just like a cancer cell becomes a burden upon the body, diverting nutrition to itself form healthy cells, interest debts consume the benefits of real production to the detriment of economic units.

The Qur’an says: “Allah deprives interest of all benefit.” [Sūrah al-Baqarah (2): 276]

The ultimate result of interest, no matter how much it may yield in returns, is always economic deprivation. That is the natural way that Allah has made the world proceed, “and you will not find any alteration in Allah’s way.” [Sūrah al-Ahzāb (33): 62]

The Difference between Islamic and Interest-Based Financing

In Islam, loans for profit are always connected to real economic activity, like products, benefits and services. The purchaser, investor, or financer is guaranteed a return based on the profit generated by that real activity. It is not possible to extend a loan for any profit that is not a direct share of the return on real activity.

As for an interest-based loan, liability to pay a return is incurred without being connected to real economic growth. This is why Islam prohibits it and permits alternative instruments like cost-plus deferred payment (bay` ājil) and advance payment of goods (salam). In doing so, it realises two objectives at once:

1. It reins in debt and prevents uncontrolled debt growth
2. It channels finance towards activities that add value and contribute to economic growth.

This makes the difference between Islamic and interest-based finance clear. In Islamic finance, the return on investment is deserved because it is a real transaction that adds economic value, whereas interest income is independent of real activity without there being any mechanism to peg it to added value. This is why interest financing results in worsening debt and inflated interest growth far in excess of any added value the financing might generate.

The Difference between Trade and Interest

From the above, the difference between cost-plus deferred payment and an interest loan can be made clear. A cost-plus deferred payment is a fixed price increase in exchange for the delayed payment. Islamic jurists explain that the time delay is a share of the price. Interest is also an increase in exchange for a time delay, so what is the difference?

The difference is that a sale is an exchange of two unlike commodities. As for a loan, it is the exchange of the same commodity. It is the difference in the commodities of a sale (money paid in exchange for goods or services) that make both parties to the sale beneficiaries. This is how value is added. It is this added value that results from the sale which justifies the increase in price in exchange for the delay in payment, since both parties to the transaction benefit from the sale.

In an interest loan, the exchange of the same commodity (money paid back in exchange for money borrowed) means that one party to the transaction benefits at the expense of the other. Any increase received by one party translated directly into a loss to the other. This is the inevitable consequence of exchanging the same commodity. This is why the increase in the money paid is an injustice with respect to an interest loan, but it is not an injustice with respect to the increased price in a sale with a deferred payment. This is in accordance with the wisdom of Allah, the Most Just of Judges.

In addition, a sale which involves the exchange of unlike commodities means that each of the two parties is engaging in a different economic activity. Linking finance directly to the sale encourages the distinct and varied economic activities that the sale generates. This is why you generally find Islamic financial instruments intrinsically linked to the specific activity being financed, including: contracts with deferred delivery (istisnā’), buying on a deferred basis and reselling on a spot basis (tawarruq), profit margins (murābahah), diminishing partnerships (mushārakah mutanāqisah), and sharecropping (muzāra`ah).

An interest loan involves the exchange of the same commodity, so it does not encourage the specification of the economic transaction. It actually does the opposite. This is why interest loans are used to finance all kinds of economic ventures without discrimination, since there is nothing in the structure of such loans to specify the commercial activities being financed. This is also why the return on an interest loan is less in comparison with specific financial instruments, since it only represents a return on the deferment of payment and does not reflect added value, which is realised by Islamic financing.