Articles on Islamic Economics

Islam and Institution of Interest Based Lending

Danial Pirani

In modern times, the institution of interest is regarded as critical for the stability of an economy. Nearly all the economic and financial institutions are, in one way or the other, connected to the interest based transactions. Interest is considered as an incentive to save money. Secular economic theory claims that the whole interest mechanism guarantees an efficient allocation of available funds. It keeps the flow of credit stable in the economy.

Today, nearly all financial institutions work on interest based transactions. They all share a common belief that interest based systems provide good incentives to invest and simultaneously earn as per the standard requirements, the result of which ultimately leads towards capital formation and economic growth.

But in practical world, this is not the case every time. What if a person bears a loss? Or what if he cannot afford to pay above the principal amount he borrowed? In both the cases, one becomes a permanent slave of the creditor. He loses his identity and becomes bound to obey what the creditor commands. Today, Pakistan has to pay half of its tax revenues in paying interest alone.

In the earliest times in recorded history, Aristotle – who is considered as a pioneer figure in secular philosophy – criticized the institution of interest. Thomas Acquinas also stated that the just price of money lent is nothing more than the principal amount lent itself. All Abrahamic religions denounced the institution of interest in clear terms. Even great thinkers like Martin Luther said: You cannot make money just with money.” Making money with money is referred to as earning something in trade by selling what does not exist.

Thomas Aquinas said: “To take usury for money lent is unjust in itself, because this is to sell what does not exist and this evidently leads to inequality which is contrary to justice.”

In the interest based lending, the lender bears no risk in the enterprise of borrower and yet demand and is guaranteed a fixed return. Hence, it leads to an inequitable distribution of income.  This can be seen by taking an example.  Suppose there are three people who consume all of their income in a given year. One of them starts with $1,000 in savings, a second with $100 and a third with zero.  At 10% interest per annum, by the end of the year, the first person has $1,100, the second has $110 while the third person has zero in his account.  If the same scenario follows in the next year, the first person will have $1,210, the second will have $121 and the third will have zero.  One can see how the wealth distribution between them gets unequal every year.  This scenario ultimately leads to an autonomous inequality in society generated by no one, but suffered by everyone. Note that those in debt paying interest that grows every year have not been added to the picture.  In their case, as interest rate continues to grow, more and more of their overall income will be consumed by interest and therefore, further exacerbating the skewed distribution of income.

On the behavioral side, the one receiving interest indirectly tags money as risk-free and work-free. This leads to a lifestyle mainly based on consumption. But more importantly, it leads to a very irresponsible attitude towards one’s own self and the society.

On the social equality front, the one paying interest becomes a slave of those who lent him money since the burden gets bigger over time. This leads to dependency and leaves self-empowerment as mere fantasy and ultimately leads towards loss of self-identity, self-honor and destruction of humanity.

John Maynard Keynes, a well-known economist of the west, who unveiled the mysteries behind the greatest economic crisis on earth (Great Depression in 1930s), also argued that the best way to revive the economy is to increase the money supply so that the rate of interest falls. A fall in the rate of interest would lead to higher investment, employment and output. In fact, Keynes held that ultimately an ideal economy is one wherein interest does not exist.

Economists like Milton Friedman, Kindle Berger and H.C. Simon regard fixed interest rates to be responsible for economic instability. Friedman contends that changes in rate of interest bring about either inflation or deflation and both are harmful to the society. He therefore argues “Our final rule for the optimum quantity of money is that it will be attained by a rate of price deflation that makes the nominal rate of interest equal to zero”. This proposition is known as Friedman’s Rule, and it is one of the most celebrated propositions in modern monetary theory.

12 replies »

  1. @Danial, It’s not just today’s transactions. You will always have to pay more than the principal if you’re paying later than today. The difference you pay is because you are taking ownership of a said amount of money for a certain period of time, and the lender is losing that control. I don’t think you will find anybody (aside from maybe your parents) who will lend you money so that you can return the exact same amount one year later. Why would anyone take that risk?

    In the same vein, if you rent an apartment, you are paying monthly installments. But at the end of the year you do not own the apartment. You have to move out as your contract has ended. You only gained partial ownership of the apartment for a set period of time. And for that ownership you were paying “rent” or monthly installments. These payments are above and beyond the “principal” which is the actual value of the apartment. The only thing that changes in a loan contract is that instead of renting a specific good or service, you rent an amount of money. Which just means that you are free to use that money on any goods or services you may later deem necessary. Why is it different when you’re renting money (which is nothing but a claim to other goods) and when you are renting something specific? I don’t understand the distinction.

    You said: “A specific amount above is justified, but not to an extent that could become a burden on the borrower”. Well who determines this amount? In a market environment, the interest rate would be determined by the market operations. By demand and supply. That is, by how many people are willing to take on business ventures that span time and how many people are willing to save. I agree that today the government is setting interest rates which is absolutely wrong. This is the cause of the business cycles. But in a free market, the interest rate would be set by supply and demand just like any other price like wheat, or corn. But who is to determine if an interest rate is too much of a burden? If you fix the interest rate or put a maximum limit on it, then this is also against the spirit of Islam, where price fixing is not allowed. Moreover, both the lender and the debtor enter into a voluntary contract which means that they both agree on the interest rate. This is the same if they were to agree on rent for a house or agree on the price of an apple. It is the borrower’s own fault if he/she took a loan at too high an interest rate. Society shouldn’t have to pay for the borrower’s mistakes. Furthermore, there are services that refinance old loans at newer, lower interest rates, which a borrower can take advantage of if he/she chooses. The market has solutions. Fixing interest rates will not solve problems, it will only make them worse (business cycles).


  2. This article is quite misleading and very inaccurate. While I appreciate that the author has taken note of the leading Keynesian and Friedmanite theory, he has not even mentioned the contribution of the Austrians on the topic. As for Keynesian theory being the pinnacle of modern economic science, the actual failures of it in our daily life should be enough to topple those claims. See Exhibit A:

    The author begins from the false assumption (which is actually common among most Islamic scholars on the topic) that interest is basically risk free money. In reality, that is not the case. Debtors go bankrupt. Bonds lose value. Businesses go broke. And all of this affects the lender’s principal. That is why, we have credit rating agencies in the first place which determine how much of a risk, a debtor can bear and what the different risks are. If loaning were risk free, there would be no reason to have credit ratings nor would it be a problem to get a personal loan without a credit check or interview. Recently, Pakistan is on the list of 11 countries nearing bankruptcy Which means that lenders who loaned money to Pakistan, have a high risk of losing all their money. As it stands, the basic assumption is flawed.

    There is risk involved in lending and lenders commonly lose their money lent. In this regard, lending is no different from any other form of investment. Another mistake the author commits is to confuse money and capital. Here, the Austrians provide a more detailed understanding by pointing out that money is not capital, it is merely the claim to capital. Lending out money is similar to saying that you can have this claim to capital goods for this much time to build some sort of a business that could generate a future income. It is an exchange of present consumption with the *expectation* of future consumption. Note that it is still an *expectation* and not a guarantee. If the proposed business fails, the lender not only loses his future income, but his present principal as well. Also note that it isn’t “making money out of thin air” because something very real has been given up. Some very real resources have been removed from personal consumption and given over for the debtor to make use of.

    In light of the above clarifications, the author’s example of the rich-poor disparity is quite ludicrous. Where is the rich man getting the money? Why can’t the poor man earn money for himself? Would it not be possible for the rich man to make a bad decision and go bankrupt and the poor man to work hard enough to start a small business? Again a wrong assumption is made, that the situation keeps on continuing as it is, which does not hold up in real life.

    Finally, the author overlooks time preference in his discussion. Lending money involves time. It is forgoing of purchasing power today for an expected return tomorrow. In general, any human being prefers to consume now rather than later. Why would anyone lend his/her money only to be returned the same amount some time later? Why would he take the risk? If, as the author would like to conclude, interest were abolished, there would be no lending. If there are no other means to invest in long term projects, capital development and therefore economic progress would grind to a halt. Is this the ideal outcome for the author?


    • Thanks a lot Zohair for the comment, feedback and identifying further sources to read for the author. We appreciate healthy criticism and different perspectives. Just a quick clarification that lending for interest is a transaction that may result in default, but default is not a feature in the legal contract. When some Islamic Economists regard lending for interest as risk-free, it is not with regards to being default risk-free, it is because the required risk for permissible return from a monetary investment is not undertaken in the light of Islamic principles. When Quran contrasts Riba with trade, one has to see where the contrast in trade and lending for interest lies in. It lies in the fact that a trader earns return on investment by taking the risk that the goods/services he is selling in the market, may remain unsold or sold at prices which may not cover costs. Furthermore, the return made on each transaction ends with it and for further return, the investment has to bear these same risks every time. Regarding the effect of interest based loans on development, there are several studies which had estimated the impact. Please have a look at some of that literature cited in this article:


      • Thanks for your reply. I’d like to mention a few points. I’m a bit confused as to your difference between a contract and a transaction. To me both are the same thing. An on the spot transaction is simply a contract that begins and ends on the present time. While other contracts might span different time periods. I don’t think we disagree on the fact that contracts can in fact span time.

        In a monetary investment endeavour, the only risk taken is default risk. Because only money is being forwarded, it is also only money that can be lost. And there is risk involved in losing that amount in any kind of investment. Be it stocks, bonds, loans or anything else. Even if one is not forwarding money, but is working with the capital goods himself, he still has the chance to lose his initial capital. By adding money to the equation, we do not move into a different dimension, money is only a convenience, a unit of account. The underlying fabric stays the same.

        For your example of the trader, this is not much different than the lender. Barring consumer loans, a lender would forward his money to businessmen, or in simple terms, traders. Those traders would then run the risks of business and because of this risk the lender may lose his investment. Loaned money still remains in the same trade dimension. Because trade is the only real way to earn a profit.

        As for the continuing returns, these are also not guaranteed. Each payment runs a risk of default. The underlying business could die at any moment causing the lender to lose the rest of his payments. This is not very different to a worker’s wages. After all, a worker also signs a contract which “guarantees” him a known sum of money periodically in exchange of services rendered. In the case of a loan investment the service rendered is the money forwarded itself (in other words the claim to current capital goods). And of course, wage earners also run the risk of having their employer downsize or go out of business entirely.

        Yes, the Quran contrasts trade with Riba. However, no Islamic scholar to my knowledge has been able to accurately explain what this difference is. My purpose in this discussion is to highlight this issue. Modern economic thought (particularly Austrian) has identified exactly why interest is important and also what it means. In light of this, some new arguments must be brought forth to explain the difference between Riba and trade.

        Ref: The Pure Time Preference Theory of Interest

        Final note on the negative impacts of debt. Yes of course there are negative impacts of debt on a personal level. But this is true of a large number of other things. Certain foods are bad for people, and are much worse for certain people. But people still use those foods for sustenance. There are multiple more examples in this world. Practically everything has side-effects.

        It is important to note that the examples you cite in the article relate to government debt. The Austrians have pointed out that government spending (especially deficit or debt financed spending ) is an all around bad thing. It does not improve situations, it can in fact exacerbate things. Specifically, government spending as well as government manipulation of the interest rate affects market signals and causes boom and bust cycles. You may be interested to refer to the Austrian Business Cycle Theory. There is a video lecture at the following link

        As opposed to government spending, private investment spending ultimately leads to more capital development and more advanced stages of production. All of which would lead to an increase in the general welfare of the people of a society. This is because unlike government spending, private investment is directed by market signals, which in turn are a reflection of people’s wants and desires.

        I hope I have made my position clear. I was originally intending for a short reply, but this has grown to be a big comment 🙂 Please feel free to ask me anything you’d like.


      • Dear Zohair, being against interest is not intended to support interest free lending. The point refuted is that interest should not be charged above the principal which is quite common in today’s transactions. If you take a loan today and pay it in instalments, the amount of interest charged on that will be greater than that of principal deducted. That is what is not correct. A specific amount above is justified, but not to an extent that could become a burden on the borrower. For full details, I can send you my detailed article which is 9 pages in length. This is only sort of highlight to it.


      • Dear Danial, I appreciate the article and efforts; however, the above comment is not representative of Islamic scholarship. They argue that a loan contract is non-compensatory. Hence, any return over and above the principal is interest and it does not differentiate between more burden or less burden. There are alternatives and which are used in Islamic banking and they have had much better results in terms of risk management, sustainability and there is possibility of securitization. In those transactions, there is no loan of money, rather a lease agreement followed by a separate sale agreement.


  3. Very simplistic article. The examples used to illustrate inequitable distribution of income criticizes the person who chooses to forgo consumption and save his money. In a world where inflation can rapidly deplete the real value of money, how will you compensate those willing to save? As far as Islamic banking products are concerned, I work in capital markets and I have seen first hand how Sukuk and other modes of “Shari’ah Compliant” financing are very similar to conventional debt instruments. Focus your efforts on restricting “Usury” i.e. a very high level of interest which is intended to entrap the borrower.


    • Brother Mustafa, thanks for the comment. Your comment is slightly modified and published in a moderated form. These days there is a famous book by Thomas Piketty “Capital in the 21st Century” that has created a lot buzz in academic circles. Also, even before that book, economists like Keynes, Fischer, Joseph Schumpeter etc have written on interest. In Marx’s “Das Capital”, Volume III, Ch#24 starts with: ‘The relations of capital assume their most externalised and most fetish-like form in interest-bearing capital.’ In what is considered the most pioneer and famous book in Macroeconomics, Keynes said ““Interest today rewards no genuine sacrifice . . . The owner of capital can obtain interest because capital is scarce . . . [But] there are no intrinsic reasons for the scarcity of capital”. On the other hand, strictly from an Islamic perspective, the agreed upon definition is ‘every loan that draws a stipulated return over the principal amount is interest’. So, the definition includes simple interest, compound interest and interest on consumption loans as well as on commercial loans. I hope it clarifies.


    • Dear Mustafa, the thing which is against Islamic principles is interest amount, which is charged above the principal amount lent. It is common in mortgage loans. However, in my view, a reasonable amount can be charged for time value of money. In my view, this is not against Islamic injunctions. But an amount that eats away all the wealth of the borrower is disdainful.


      • Again Mustafa, I can send you my detailed article for clarification. Due to word limit, it could not be posted in full.


      • Dear Danial, I appreciate your comment; however, the above comment is not representative of Islamic scholarship or mainstream Islamic finance practice. A loan contract is non-compensatory as per Islam. Hence, any return over and above the principal is interest and it does not differentiate between more burden or less burden. The alternatives used in Islamic finance like Ijarah and Diminishing Musharakah are much better in terms of risk management, sustainability and there is possibility of securitization. In those transactions, there is no loan of money, rather a lease agreement followed by a separate sale agreement.


      • Firstly, let me compliment you on the outstanding work done on this site by everyone.

        Now, I disagree. Time value of money is “interest”. It cannot be seen as acceptable or as separate from interest. Time value of money is based on potential earning capacity in future. “Potential” which means that it is contingent upon future events. This is not acceptable within the Islamic framework.


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