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` ajil) and advance payment of goods (salam). In doing so, it realizes 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.
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 is 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 (istisna’), buying on a deferred basis and reselling on a spot basis (tawarruq), profit margins (murabahah), diminishing partnerships (musharakah mutanaqisah), and sharecropping (muzara`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 realized by Islamic financing.
Excerpted from Islam Today.