Globally, according to IMF, many kinds of debt, including national, household, and private debt has reached new all-time highs during the pandemic1. On a smaller scale, in Indonesia, reports on online loan sharks known as pinjol has reached over 50.000 reports in 20212. These pinjol, especially illegal ones, has a huge interest rate of up to 10% daily, and uses very harsh methods in loan collection3, 4.
Debt and interest has always been important in the modern economy, but its influence continues to increase as the modern economy develops. On the other hand, Islamic finance, which does not allow interest, also continues to grow at a rapid pace, showing that an interest-free system is feasible and has large influence in the society. This article explores the role of debt in the modern economy and what its position is in Islam. The issue of interest, and its prohibition in Islam, is also discussed.
1. The Role Of Debt In The Modern Economy
Debt in a credit transaction is a commitment to pay an amount to someone in the future5. Within the economy, debt serves to ease income constraints from an individual’s expenditure6. It spurs economies to grow by allowing business to invest and individuals to spend without having current income. Debt would also improve the efficiency of capital allocation and theoretically shift risk to those who can bear it. Governments can use debt to raise money for development or smooth taxes against variable expenditures7. They can also use it to finance fiscal policies to stabilize the macroeconomy.
Debt becomes even more important in the modern economy, where the money being used is credit money, which is put into circulation by a loan5. Furthermore, as the role of financial intermediaries rises, savings are used to finance debt, instead of being stagnant. This means that both savings and debt are very much linked through the nature of money and financial institutions.
However, excess debt can lead to disasters. As debt increases, the creditor’s ability to repay becomes more sensitive to shocks and drops in income6. For households and enterprises, higher debt would also hinder the ability to smooth consumption and investment8. In a larger scope, higher debt creates vulnerabilities which amplify and transmit shock. Higher nominal debt would also raise volatility, increase fragility, and reduce average growth. This had happened in the 2008 crisis, where high debt did not directly cause the crisis, but it made the impact of the crisis worse.
This is a concern as in 2020, the overall global debt has reached a new record of 256% of GDP, as the pandemic causes output to plummet and fiscal burden to rise1, 10. Borrowing from government and private non-financial corporations and households also reached record levels. Worryingly, this is not a one-time peak created by the pandemic, but a continuation of an ongoing trend. For example, according to IMF data, Indonesian household debt has tripled from 2000 to 2020, and the same trend is seen in many countries across the world.
On an individual scale, debt problems have a large link with mental health11. According to the Money and Mental Health survey in the UK, 46% of people having debt problems also have a mental health problem. Debt and mental health creates a continuous cycle. Financial difficulty would cause stress and anxiety, and in turn, these mental problems would make it harder to solve their financial problems.
2. Debt In Islam
The general term regarding debt in Islam is Dayn. Dayn is the arabic term for a debt that is created by any other contract, including sale and loan12. For example, when a bank sells a house to its customer in a credit sale, a dayn is created. Generally, no extra return can be added to a debt once it is established, as this falls under the prohibition of riba.
On every kind of debt, whether it is for goods or money, the Quran instructs the parties to have witnesses and documentation. Some scholars even rule it as compulsory12. The instruction is given in the following verse:
يٰٓاَيُّهَا الَّذِيْنَ اٰمَنُوْٓا اِذَا تَدَايَنْتُمْ بِدَيْنٍ اِلٰٓى اَجَلٍ مُّسَمًّى فَاكْتُبُوْهُۗ
”O you who have believed, when you contract a debt for a specified term, write it down...” (Quran 2:282)
وَاسْتَشْهِدُوْا شَهِيْدَيْنِ مِنْ رِّجَالِكُمْۚ
“And bring to witness two witnesses from among your men;...” (Quran 2:282)
These instructions serve as safeguards against future disputes, as disputes based on loans are very common. This is one example of how the Quran safeguards the wealth of people, where wealth is one of the maqasid (goals) of sharia.
Another term regarding debt, Qardh, is more specific than dayn, as qardh is limited to loans. Qardh linguistically means to cut, as this contract cuts the ownership of an item from a creditor and gives it to the debtor12. According to AAOIFI, qardh is the transfer of fungible wealth ownership, and it is binding to return a similar wealth. Qardh is limited to fungible items, because non-fungible items cannot be returned with a similar item if it is lost or destroyed.
The legality of qardh is based on the sunnah and consensus of the jurists. Qardh is categorized a charity, as the prophet (PBUH) likened lending to another muslim twice is with giving once in charity.
”No Muslim lends a loan to another Muslim twice but it will be like giving it once in charity” (Ibn Majah)
A loan is considered charity as it would create ease for the borrower, who mostly would not ask for a loan except for a specific need. The virtuosity of qardh is based on the prohibition of riba, which means qardh would have to be an interest-free loan to be sharia-compliant.
To secure the return of a debt, it is allowed for the creditor to ask for a guarantee, according to rulings from DSN MUI. This guarantee can be in any form sharia-compliant guarantee, such as mortgage or personal guarantee. Qard can have a certain period of repayment, and if it is not stipulated, the loan has to be returned on demand. It is also not allowed to stipulate a commutative contract within a qard, as this can be categorized as an excess benefit.
2.1 Debtor Perspective
For the debtor, debt is something that is allowed, as the prophet (PBUH) is recorded to have taken on debt12. However, the prophet (PBUH) is also recorded to often pray to be protected from debt, implying that it is something to be avoided for a Muslim13.
Aisyah said ”The Messenger of Allah [SAW] often used to seek refuge (with Allah) from debt and sin. I said: ’O Messenger of Allah, how often you seek refuge from debt!’ He said: ’Whoever gets into debt speaks and lies, and makes a promise and breaks it.’” (an-Nasa’i)
An important aspect to note is that Islam prohibits waste fulness and extravagance14. This means that debt for excessive and useless consumption are especially disliked. Furthermore Islam also pushes people to live modestly within their means, which further discourages debt. The prophet (PBUH) is recorded to have an extremely modest life such as in eating:
Jabir b. ’Abdullah reported that Allah’s Apostle (PBUH) asked his family for food. They (the members of his household) said: We have nothing with us but vinegar. He asked for it, he began to eat it, and then said: Vinegar is a good food, vinegar is a good food. (Muslim)
If someone was to take on debt, he must have a sincere intention to repay, and procrastination from an able debtor is an injustice. There are firm warnings for people who do not pay their debt. The prophet (PBUH) had even refused to offer funeral prayer to a companion until his debt was paid. The following shows how a debtor should act in his loan:
”Whoever takes the money of the people with the intention of repaying it, Allah will repay it on his behalf, and who ever takes it in order to spoil it, then Allah will spoil him.” (Bukhari)
”Procrastination (delay) in repaying debts by a wealthy person is injustice.” (Bukhari)
2.2 Creditor Perspective
For the creditor, Islamic law encourages people to give ease to the debtor by giving time or even waiving the loan12. Regarding qardh, The prophet (PBUH) encourages people to lend to others as this would give ease and is a form of charity. The following is some examples of how Islamic law encourage lending leniently:
وَاِنْ كَانَ ذُوْ عُسْرَةٍ فَنَظِرَةٌ اِلٰى مَيْسَرَةٍ ۗ وَاَنْ تَصَدَّقُوْا خَيْرٌ لَّكُمْ اِنْ كُنْتُمْ تَعْلَمُوْنَ
”And if someone is in hardship, then [let there be] postponement until [a time of] ease. But if you give [from your right as] charity, then it is better for you, if you only knew.” (Quran 2:280)
”Once a man died and was asked, ’What did you use to say (or do) (in your life time)?’ He replied, ’I was a businessman and used to give time to the rich to repay his debt and (used to) deduct part of the debt of the poor.’ So he was forgiven (his sins.).” (Bukhari)
3. Interest In Islam
Any form of excess in debt is categorized as riba in Islam. Riba is a major sin and is categorized by the prophet (PBUH) as one of the seven great destructive sins.
The Prophet (PBUH) said, ”Avoid the seven great destructive sins.” The people enquire, ”O Allah’s Messenger (PBUH)! What are they?” He said, ”To join others in worship along with Allah, to practice sorcery, to kill the life which Allah has forbidden except for a just cause, (according to Islamic law), to eat up Riba (usury)...” (Bukhari)
Riba can be divided into riba dayn (debt) and tiba ba’i (sale), and interest is a part of riba dayn. Riba dayn means increasing the burden of someone who is in debt15. The main principle that governs riba dayn is every debt that gives a benefit is riba. We can use the following guidelines to determine whether a benefit is riba15:
- The benefit separate from the loan are prohibited, while benefits that are attached to a loan are allowed. For example the safety in creating a bank account based on qardh is allowed.
- The benefit only received by the creditor are prohibited, while benefits that are received by both parties or only the borrower are allowed. This includes increase in payment time or waiving the loan.
- The benefit stipulated in the contract are prohibited, while unstipulated benefits are allowed. This includes unstipulated gift given by the lender after the loan is paid off.
- Unstipulated benefit that is given before the loan is paid off is prohibited.
The benefit that is categorized in riba does not have to be monetary. It can be other goods or even services. There is no minimal value of a benefit to be categorized as riba15. This is backed by statements of scholars such as Imam Malik and Ibn Qudamah.
Riba is forbidden in Islam based on the Quran and Hadith. The warnings regarding riba are very severe, including a war with Allah and his Messenger, and sins which are bigger than adultery:
يٰٓاَيُّهَا الَّذِيْنَ اٰمَنُوا اتَّقُوا اللّٰهَ وَذَرُوْا مَا بَقِيَ مِنَ الرِّبٰوٓا اِنْ كُنْتُمْ مُّؤْمِنِيْنَ - ٢٧٨
فَاِنْ لَّمْ تَفْعَلُوْا فَأْذَنُوْا بِحَرْبٍ مِّنَ اللّٰهِ وَرَسُوْلِهٖۚ وَاِنْ تُبْتُمْ فَلَكُمْ رُءُوْسُ اَمْوَالِكُمْۚ لَا تَظْلِمُوْنَ وَلَا تُظْلَمُوْن - ٢٧٩
”O you who have believed, fear Allah and give up what remains [due to you] of interest, if you should be believers. And if you do not, then be informed of a war [against you] from Allah and His Messenger. But if you repent, you may have your principal - [thus] you do no wrong, nor are you wronged.” (Quran 2:278-279)
”There are seventy degrees of usury, the least of which is equivalent to a man having intercourse with his mother.” (Ibn Majah)
3.1 Impact Of Interest
One of the largest impacts of interest is that it creates an accumulation of wealth in a minority12. This is created as interest makes lenders always have a net positive, but not the borrowers16. Therefore, this would increase inequality in the economy.
According to Ibn Qayyim, the prohibition of riba is due to the increase of debtor burden, which is mostly poor. On the other hand, the lender gets more wealth without any justification or benefit for the borrower. The practice of interest would also block interest-free loans, as people expect interest when lending17.
The large supply of interest-based credit also would promote overspending, which goes against the prohibition of wastefulness and extravagance12. And overspending would create economic instability due to decrease in savings and investments, and increase in inflation.
Another impact of interest is hindering activities in the real economy12. According to al-Ghazali, the ease of interest would make people not bother to be involved in real economic activity. In economic terms, the existence of risk-free capital would reduce productive investment.
3.2 Interest And Trade
In the Islamic economic system, the counterpart of interest is trade, as indicated in the following verse:
وَاَحَلَّ اللّٰهُ الْبَيْعَ وَحَرَّمَ الرِّبٰواۗ
“...But Allah has permitted trade and has forbidden interest...” (Quran 2:275)
One of the main differences between trade and riba is the issue of risk. In riba, the lender assumes no risk and always has a net positive16. While in a sale, there is always risk as in Islam prohibits a sale until the seller has received the item. This goes with the Islamic principle that no profit goes without risk18.
Another difference is regarding their connection with the real economy, which is an important theme in Islamic Finance19. Interest has no connection with the real economy, and only creates value for the lender. While trade is directly connected with the real economy and adds value to it through the movement of goods and services18. This connection would also create economic stability19.
Therefore, Islamic financial institutions use various trade contracts to finance debt. These include murabahah, a sale contract with a profit margin; Salam, a prepaid contract with deferred goods; istishna, a manufacturing contract; and ijarah, a service-based sale contract. Using these contracts, Islamic Financing would be directly connected to the real economy, and the business risk would be shared more evenly between the financier and the buyer12.
Both theoretically and practically, debt is an essential cog in the modern economy and fulfills many roles. However, too much debt creates many problems, from an individual to a global scale, including fragility, mental health, and can even lead to severe economic crises. In Islam, debt in itself is allowed, and giving out a loan is even considered a charity. However, taking debt is not encouraged and there is a firm warning on people who do not pay their debts.
Any amount of interest, on the other hand, is strictly forbidden and is categorized as a major sin. Interest is forbidden in Islam as it would cause inequality and a disconnect with the real economy. To solve this, Islamic Finance uses sale transactions in place of interest-based debt. This would create a direct connection to the real economy and share the business risk between both parties.