Housing a Dilemma

Recent world events and emerging trends in Islam have sparked a debate between literalists and modernists, which at its core represents a battle for the soul of the Muslim ummah. But for all the unresolved philosophical, spiritual and life-or-death issues dividing the Muslim world, one question continues to linger: “Is it permitted to have a mortgage?”

Interest based mortgages are contentious because of the Islamic prohibition against riba, which has alternatively been defined as interest or usury (very high interest). The Quran declares: “O you who believe, fear God and give up what remains of your claims of riba if you are truly believers. If you do not, then take notice of war from God and His Apostle (2:278).”

Despite the clarity of the prohibition, there remain areas of confusion in interpreting it for the modern world. Interpretations can broadly be categorized as using either a literal approach or a purposive approach. In a literal interpretation, the reader takes the plain meaning of the words as written. In a purposive interpretation, the reader extracts meaning using interpretive modes such as context, knowledge and social development. In many important legal cases, courts have struggled with questions of interpretation. When it comes to matters of the eternal soul, however, the stakes could not be higher.

Conventional or Islamic?

Interest, in economic terms, is the cost of acquiring now but paying later. Since the borrower has to return the principal to the lender, the interest rate is best thought of as the price of renting money. Interest is calculated either on a compound rate or non-compounding (simple) rate. A simple interest rate means that the borrower only pays interest on the borrowed amount. With compound interest, the borrower pays interest on the borrowed amount and on any previously accrued interest. Conventional home mortgages are calculated based on compound interest.

One view is that riba refers only to usury and perhaps to compound interest. Some Muslims point to micro-financier Muhammad Yunus’ Grameen Bank. The Grameen Bank offers small loans to help some of Bangladesh’s poorest finance small businesses, homes or education. Compared to costlier compound mortgages, it charges a higher rate of simple interest on a declining basis (money goes towards the principal first). This venture has improved the lives of so many people that it won Yunus a Nobel Prize - a big return for a lot of little loans.

“Shariah-approved” Islamic mortgages take a more literal approach to the riba question by using a structure that avoids historically prohibited interest transactions. In a typical arrangement, borrowers give a down-payment to the bank for a house, with the bank providing the rest of the purchase price. The bank takes title to the house and charges borrowers a “rental rate” until they pay back the portion of the purchase price the bank provided. In some Islamic financing schemes this rental charge is actually based on the prevailing interest rate. Regardless of structure, most Islamic financial models end up being more expensive than conventional mortgages with less protection for a defaulting borrower.

Islamic finance is a very profitable business throughout the Muslim world and increasingly in the United Kingdom and North America, as Muslims look for a permitted way to finance high cost expenditures. But not all Muslims are convinced these pricier financial products are truly Islamic. Muslims are left to choose between an oddly structured Islamic mortgage, a conventional mortgage or being left out of the real estate market entirely. Since non-participation in the real estate market generally leads to poorer, less secure communities, conventional mortgages tend to be the norm.

Another approach to the interpretation problem, the purposive approach, would be to determine why Islam prohibits riba in the first place. Tarek El Diwany attempts to answer this question in his book The Problem With Interest. Some of his most compelling arguments are outlined below.

Increasing Debts

El Diwany argues that money at interest does not obey the rules of the natural world. In the natural world, things decay or at best, stay the same. But money on interest grows exponentially over time. Imagine something that can be purchased with $100 that is, without any modifications, placed in storage for 10 years. If instead, you lend $100 at 5% (compounding annually) to a borrower, you will receive $162.89 after 10 years (and over a million dollars after 189 years) - the quantity of money only increases. If the stored item is now scarce it may go up in price, while products like wine may be valued more after decay. But these are exceptions to the general rule that things lose value over time and decay represents a loss of wealth. To get ahead, a borrower has the difficult task of going into the real world, where decay is a reality, and using the borrowed money to create wealth faster than the interest rate.  For a borrower using credit to meet daily survival needs, the situation is nearly hopeless.

Discounting the Future

El Diwany also suggests that the existence of an interest rate and its corollary, discounting, may have a perverse affect on intergenerational equality. Discounting is the calculation of the present value of future wealth. It works on the principle that if a dollar today is worth a $1 plus interest in the future, a future dollar is worth less than a dollar today. Starting with $100 at a 5% interest rate, after ten years that money is worth only $61.39 in today’s dollars. In a discounting model that assumes constant prices, this also means that logging a tree today is worth more than saving it for tomorrow.  Future generations will suffer as debtor nations clear forests to grow cash crops for hard currency to pay interest to foreign creditors. Three of the top five countries with the highest rates of deforestation are also in the top five for highest external national debt (Brazil, Indonesia and Mexico, 2000).

Fractional Reserve Banking

El Diwany’s most sophisticated critique of interest relates to fractional reserve banking. Fractional reserve banking refers to the fact that banks are only required to hold a small fraction of deposits in the ‘vault’. The concept started when the early goldsmith banks learned that people withdrew only a small percentage of their total deposits on any given day. By keeping only this small percentage, the banks discovered that the remaining deposits could be used for interest bearing loans.

A simplified (but still complicated) example may illustrate the problem with this system. Suppose an economy has $100 of total wealth controlled by Depositor. She deposits the money into Only Bank. Only Bank holds $10 for potential withdrawals and lends the other $90 to Holder at interest. Holder puts that $90 into his account at Only Bank. Of that $90, Only Bank holds $9 and lends out the other $81 at interest to a Borrower.

Check the results: Only Bank owes $100 to Depositor and $90 to Holder, totaling $190. Holder owes the $90 to the Bank and Borrower owes $81, totaling $171. Only Bank is holding $19 in reserve which accounts for the difference between its deposits and its lending. But if there is only $100 in the economy to begin with, how can the two borrowers owe interest on $171?

Instead of creating real wealth, banks create highly profitable interest-bearing debt obligations. In a simple economy, this system would quickly collapse. But in a modern economy, the reality of “bank money” is hidden in a complex system of multiple banks circulating trillions of dollars. But the effects can still be seen - El Diwany argues that the excess supply of “bank money” is the true cause of inflation.

In order to sustain this system of perpetual debt, people need to produce, consume and circulate cash in large quantities. When there is an economic slowdown and people are no longer able to meet the minimum obligations on their debt, the economic bubble bursts. People who are heavily indebted suffer the most.

Although it is generally accepted that the national debt of the United States greatly outreaches the total capacity of their economy, economic slowdowns rarely lead to a complete collapse. This is mostly because lenders have faith that the United States economy can produce enough real wealth to service their debt obligations. In poorer countries, such as Africa and South America, lenders have less faith. Debt obligations have devastated many regions as desperate economies produce less food and extract natural resources for the export market.

The Islamic System

Cumulatively, El Diwany argues that interest is forbidden because it allows the rich to become richer while the poor often become poorer regardless of how hard they work. The Islamic economic system is a free market system and there is no prohibition against becoming rich by working hard and using your God-given talents: interest is prohibited because you gain wealth from others without working for it.

Opponents of a zero-interest system have argued that without interest to encourage deposits people would resort to hoarding their money. El Diwany argues that Islam has addressed this problem by imposing the 2.5% zakat tax on money and all other forms of stored wealth. Individuals who do not invest their wealth in capital ventures will watch it decay in the same manner as natural products do in the real world. In theory, such a system would eliminate the inefficient boom and bust business cycle and slow growth to environmentally tolerable levels. Of course, the zero-interest debate is mostly academic since a true Islamic economic system is virtually non-existent.

Interpretative Issues

If you accept the purposes outlined above, then it appears that Islamic economics is largely incompatible with an interest-based economy. “Shariah-approved” finance may be servicing a need in Muslim communities, but it is difficult to see how a more expensive mortgage addresses the social ills of interest.  In religious matters, the spirit of the law is as important as the letter.

Unlike Islamic financiers, the Grameen Bank does not advertise itself as Shariah compliant. But Muslims who support an interpretation of interest that would permit Grameen-style lending can at least argue that the Bank’s loans are actually improving the lives of its borrowers. Amazingly, the Grameen Bank boasts a 98% repayment profile despite lending to some of Bangladesh’s least creditworthy borrowers.

Others may find that such an open interpretation strays too far from the written word. A purposive interpretation should not make halal what is otherwise haram. But the fundamental question for Muslims is whether Islam is a set of rules to be blindly obeyed or an alternative to the organized chaos of the current world order. If it is the former, then there will always be ways to find loopholes. If it is the latter, then Muslims need to be bold and creative in finding alternatives to the current system rather than trying to mimic it.

The purposive approach to interpretation is not without risk. No one can really be certain about the true intentions of the Quran.  But it is not sufficient simply to rely on literal translations. If Islamic law is to remain vibrant, then Muslims must continually engage with the deeper meaning of the Quran. When approached with clarity of reason and purity of heart the ancient text becomes a living, breathing guide. If the Quran provides a definitive explanation of the world, then the better we understand how the world works, the better we can understand its everlasting wisdom.

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