Islamic Finance

islamic finance

Every American has a right to participate in economic society, to own a home, and to achieve their long-term dreams. And they also have a right to practice their faith to the best of their ability which, in many cases, means abstaining from participation in any interest-based forms of financing. Historically, this has created a unique set of conflicts for American Muslims—at least until the recent emergence of faith-friendly financing, which began about 50 years ago and has expanded ever since. 

In response to this ongoing need, new forms of faith-friendly financing have emerged. Despite Islam’s general prohibition against interest-bearing loans (a term that describes most mortgages issued in the United States), it is now possible for many Muslims to ethically purchase a home with more money than they currently possess. Achieving the American Dream of homeownership and adhering to the basic tenants of Islam is more possible than ever before. 

In this comprehensive guide, we will discuss the most important things to know about Islamic finance, including what it is and how it can help Muslims faithfully secure major purchases.  

What Is Islamic Finance? 

When compared to traditional finance, Islamic finance typically avoids the use of interest and instead offers halal alternatives. 

Islamic finance is a well-defined set of financial practices that are specifically chosen to be compliant with Islamic Law (Shariah). This particular set of practices is designed to help Muslims achieve long-term financial goals—such as owning a home—without having to directly participate in any practices that contradict their faith, such as the ongoing collection of interest. 

For as long as money has existed, it has been a consistent enabler of both prosperity and conflict. In the best of times, money can be used as a medium of exchange that can help people of all kinds live the good life. But in the worst of times, money can produce a variety of issues, including war, corruption, exploitation, and more. 

For better or for worse, money has become a permanent component of the international economic system. But how this resource can be used effectively—while avoiding its pitfalls—remains an ongoing matter of debate. The things you should and should not be able to do with money have been a central component of various philosophies for thousands of years across nearly every society. There are many world religions that have consistently warned about the risks presented by the use of money—particularly, usury, or the act of collecting interest—and Islam has played a pivotal role in this broader, global conversation. 

Ultimately, everyone who participates in the economic system must decide their personal ethics regarding the use of money, borrowing, and the collection of interest. For many faithful Muslims, interest financing is something they believe should be avoided altogether. As we will explain throughout this guide, there are several references contained in the Quran that make it clear that the collection of and participation in the use of usury is something that, in nearly all cases, is morally unacceptable. 

In the modern world, this has created a unique set of challenges for many Muslims, particularly those living in western countries (such as the United States) that are heavily reliant on the use of interest-collecting financial institutions for mortgages, credit cards, and other types of financing. 

Islamic finance and Islamic banking are like many other socially responsible investment structures; there is a large group of people (about 3 million in the United States) who have a specific set of needs and values, and financial institutions have adjusted themselves accordingly. Through the general use of Islamic finance, it has become possible for Muslims to make large-scale investments while also avoiding the use of usury (the collection of interest). 

What Makes Islamic Finance Different? 

The Difference Between Islamic Financing and Traditional Financing 

There are quite a few differences between Islamic financing and traditional financing. While some faithful Muslims will participate in the traditional financing process, most consider this process to be a direct contradiction of their values and are, therefore, looking to secure a more halal (permissible) form of financing. 

The most important difference between Islamic financing and traditional financing is the charging of interest on a mortgage. With many conventional financing options, homeowners—over the course of 30 years—will often end up paying more money in interest than they do in principle. Interest is a huge component of the traditional mortgage market, though many people might consider the charging of even modest interest rates to be immoral. 

Islamic Law explicitly forbids the charging of interest. Therefore, any Islamic loan that can be considered halal will avoid the incorporation of interest. These loans are structured quite a bit differently—in most cases, rather than paying interest, people with Islamic loans will continue buying a larger portion of their home from their original financing partner until, eventually, they own the entire property. In general, not only is this practice more compliant with the teachings of the Quran, but it also makes the process of becoming an outright homeowner significantly more affordable. 

The History of Islamic Finance 

The origins of Islamic banking and Islamic finance can be traced back to the original teachings of Muhammad, who once suggested that “all forms of interest and riba are hence prohibited.” When translated into English, riba typically means interest, excess, or usury (considered by most to mean “excessive interest”.) 

The Islamic prohibition against the collection of interest is not unfounded. In fact, interest is also a frequent topic of discussion in other Abrahamic religions although, generally, Muslims take the warning against the use of interest much more seriously than members of other belief systems. Muhammad believed that interest would inevitably lead to exploitation, which has been an undeniable reality ever since his lifetime. To put into terms for non-Muslims—Muhammad considered the use of any type of interest to be exploitive, just as most non-Muslim people currently consider the use of “payday loans” and other forms of excessive interest-bearing financing to be exploitive today. 

The primary focus of the Islamic prohibition of usury, or riba, has been justice. While it might seem as if borrowing with interest can be “temporarily beneficial” for many people, the ultimate consequence of participating in this system is injustice—the rich become wealthier as a result of taking advantage of those who are in need, while the poor become relatively poorer (even if they’ve secured a mortgage) due to the broader expansion and corruption of the debt and monetary system. 

The general Islamic prohibition of interest has lasted for more than 1,400 years (with some exceptions). Muslims that are seriously committed to the teaching of Islam have realized that, though the world has been changing at an incredible pace, their founding principles and beliefs should remain as unaltered as possible. 

The issue of the use of riba has been revisited many times throughout Islamic and global economic history. More recently, in the 1970s, there was a considerable revival of the broader dialogue regarding riba throughout the Muslim world. This was a period where the existence of the “global financial system” was seemingly unavoidable, though Muslims who—rightfully—still wanted to participate in the economy began looking for alternative options. 

Following a series of several “Conferences on Islamic Banking”, which were held in Pakistan, Egypt, Saudi Arabia, and eventually the United Kingdom (all between 1972 and 1977), Muslims had their first genuine opportunity to establish an interest-free banking community. These conferences were critical not only for people living in Muslim-majority nations in the Middle East and North Africa, but especially for Muslim minorities living in the US, UK, and elsewhere throughout the world. 

During these conferences, a combination of Sufis, scholars, and even secular economists determined that—per the Quran—the issuance of any form of interest was considered riba (which is “haram”, or forbidden by Islamic Law). As a result, it appeared that any middle-class Muslim who wanted to secure a mortgage while maintaining their faith would need to look outside of the “traditional” mortgage system. 

Over the next few decades, the emergence of Islamic Banking would gain quite a bit of traction in the west. The need for alternative banking options was especially high in countries, including the US and UK, that had fast-growing Muslim populations. While this transformation was gradual, it was still very important. Today, contrary to many years ago, Muslims can now ethically finance major purchases such as mortgages while also maintaining their faith. This has represented a major transformation in the global banking system, as well as a significant movement towards justice

What Principles Is the Islamic Economic and Financial System Built On? 

As suggested, the general weariness against the use of interest (usury) is not exclusive to Islam—in fact, most global belief systems generally discourage excessive or exploitive borrowing, even though this level of discouragement is much clearer for followers of Islam than it is for followers of other belief systems.  

The book “Debt: The First 5000 Years” by David Graeber—along with many other texts—helps illustrate how the issuance and collection of debt have been an exploitive practice among nearly all cultures, dating back to the near-beginning of written history. To Muslims—and many others—accumulating debt and the exploitation of interest is something that ought to be avoided, even if it might be necessary for the most extreme circumstances (sudden medical illness, legal obligations, etc.). 

In other words, most people who are “true to their religion” would probably have at least some problems with the current debt-issuance system, regardless of whether or not they are compliant with the general principles of Shariah. But for many Muslims, the need to avoid this structurally exploitive system is even more important. Muhammad makes it clear that, at the very least, interest-bearing debt is universally harmful.  

Beyond the teachings of Muhammad, who once famously said “O believers, take not doubled and redoubled interest, and fear God so you may prosper”, there are several basic underlying principles that make the need to reject the collection of interest seemingly universal: 

  • Any harmful activities need to be avoided: for laymen, “haram” is a term that can be loosely translated to mean activities that are harmful. All Muslims have a natural obligation to avoid any activity that is considered haram. But, to be more specific, “haram” also means any activities that are explicitly outlawed by the teaching of the Quran. Some of the most notable haram activities include the consumption of alcohol and pork-based products. There are many actions that are considered haram, according to the Quran. Perhaps more importantly, the issuance of interest seems to be exceptionally haram. This means that, at least for Muslims, interest-bearing loans should be avoided to the greatest extent possible. 
  • Financial Risk Needs to be Shared: in the “traditional” financial system, risk is typically not generally held by the large banks that are issuing the loans, but held by the consumers who possess the loans. This creates a structurally unequal and exploitive playing field—in the traditional system, when a borrower fails to pay their mortgage they will lose their home while the bank gets to keep the house (meaning the risk for the bank is minimal). But in a Shariah-compliant lending system, the risk will be shared by all parties involved. 
  • Wealth Must Come from Legitimate Activity: if a person or organization is to increase their wealth, it must come from activities that are both halal and just. People who work for money and people who engage in legitimate trade and investments can consider their wealth to come from a halal source. But when someone uses money for the simple sake of making more money—as the “traditional” lending system typically dictates—that should be considered haram and rejected by the majority of most Muslims. 
  • Investments Need to Benefit Society: there are quite a few teachings from Muhammad that indicate the need that any sort of “investing” (i.e. contributing money to a specific cause) must be supplemented with a commitment to broadly benefit society. Again, this reveals how the general collection of interest (or using money to get more money) is not necessarily an ethical thing to do. Interest, on its own, benefits nobody but the lenders. Islamic-friendly investment, on the other hand, creates benefits beyond the lenders, including benefits to the poor and other individuals in need. 
  • Justice is the Ultimate Goal: in the end, all of these crucial principles have a basic underlying goal: justice. Justice is a concept that has been talked about since at least the days of Socrates and has always been a focus of Islam, in general. To put it simply, “Justice” involves actions that create the betterment of society. Of course, this exact definition is up for interpretation but if the rich are exploiting the poor (through interest), if a sustainable livelihood is pushed out of reach (because of interest), and positive change can’t occur due to interest, then Justice does not exist. But with a simple reconstruction of the broader banking system—one that eliminates the use of interest in mortgages—then Justice can potentially prevail. 

While these principles might sound “romantic” or “dramatic” to some, they are a universal component of the Islamic faith—and for good reason. If society, as a whole, can find a way to remove the exploitive nature of the mortgage-issuing industry, then more people would be able to become genuine homeowners, more people would be able to achieve the American Dream, and more people would be able to manage their monthly finances. In other words, the existence of reasonable Shariah financing options is not an outlandish reality—it is a necessity that will benefit all people, both those who are Muslim and those who are not. 

Common Misconceptions About Islamic Finance 

While many people know about the existence of Islamic Finance, very few understand just how understood this particular financial system actually is. Here are a few of the most common misconceptions about the Islamic financial system, which might be relevant to both Muslims and non-Muslims alike. 

  • The experience of acquiring an Islamic-financed loan will be much different than acquiring a traditional loan: yes, there are clear differences between Islamic and traditional financing—especially regarding the general use of interest. However, contrary to what many assume, these loans are not that different. Both involve financing a home and ensuring a just payment structure. However, what makes both Islamic banking and Islamic financing unique is that the Islamic system avoids interest and, therefore, is compliant with Shariah. 
  • The only people who can apply for an Islamic-financed mortgage are Muslims: while these loans are designed to conform to the traditional beliefs of Muslims, they are available to everyone—regardless of their faith. And considering that people of all faiths are wary of traditional finance-based loans, there are many people who obtain Islamic financing that have no association with the broader Muslim faith. 
  • Islamic financing is exceptionally complicated: it is clear that Islamic financing is different from traditional financing. But that doesn’t mean the process needs to be more complicated. In fact, in many cases, this particular form of financing will be much more streamlined and accessible, regardless of your religion. 
  • Islamic financing costs more than traditional financing: contrary to a few reports early on in the Islamic financing era, there is little evidence that Islamic financing will end up “costing more” than traditional financing. In fact, for most people who use the Islamic financing system, the total cost of owning a home will be less than when using the “traditional” system. 
  • Islamic financing is uncompetitive in the current marketplace: it might be easy to assume that Islamic financing—which is much less profit-focused and much more ethics-focused—can compete in the current environment. But Islamic financing appeals to a large portion of the population without increasing added costs. The lack of interest added, frankly, is what helps Islamic financers remain competitive. 

It is clear that Islamic financing is different from traditional financing. As suggested, the largest difference is that Islamic financing does not incorporate interest or usury of any form. Using an Islamic financing option can help many people secure a home that otherwise—either financially or ethically—would otherwise be out of reach. 

Why Islamic Finance Is Important? 

Economics and finance are important pieces of the broader conversation about justice. Islamic finance is important because it helps promote faith-based justice. 

The human experience necessitates the acceptance of a particular code of ethics. For some people, this code of ethics might include Islam, Christianity, Judaism, and everything in between. But regardless of what you might happen to believe, having a fundamental and irreversible code of ethics is key to becoming the best version of yourself that you can possibly be. It is important to think, sincerely, about what truly matters to you, what constitutes “the good life”, and the kind of person you want to be. This applies to all people. 

For many Muslims, the code of ethics outlined in the Quran is simply unavoidable. For Muslims, the Quran is a great representation of Truth and something that they naturally want to take each and every word of very seriously. When the teachings of the Quran and Muhammad suggest that a particular action—such as the issuance and the collection of interest—is wrong, that means it is genuinely wrong (haram) and is something that needs to be avoided to the greatest extent possible. 

Asking, “why is Islamic financing important” is essentially the same as asking, “why is having a belief system important?” We need to believe in something, otherwise we believe in nothing. The teachings of the Quran matter to Muslims and, for many Muslims, that means that the acceptance of riba is something that is simply unacceptable. In a country that is founded upon the principle of freedom of religion, like the U.S., this means that Islamic financing is not something that should be considered a “niche” component of the financial system, but one that is made readily available. 

Islamic Laws on Trading 

Contrary to what many people assume, not all types of trading and investing are forbidden in Islam. However, there are still a few specific rules that all Muslims will need to follow. 

One of the most commonly cited—and perhaps controversial—components of the Quran is when Muhammad claims that “Allah has permitted trade and forbidden usury.” Given the general view that “using money to make more money” is considered a form of usury, this particular quote has inspired quite a bit of debate since the origin of Islam, more than 1,400 years ago. 

When examining this quote, it appears that the teachings of Muhammad allow “trading” but prohibit “interest.” Naturally, this begs the question, if someone were to invest $100 today (in whatever asset) with the promise of collecting $110 one year from now, would this be considered the process of collecting interest? 

While we would all love to have clear-cut answers, the true answer, it seems, is it depends. First, we should keep in mind that at least one basic principle of Islamic Law necessitates that all for-profit investments ought to be made in the pursuit of some greater social good. But furthermore, as many Islamic scholars have suggested, investing and trading make sense in a lot of situations, as long as these investments and trades do not specifically contradict the teachings of Muhammad. 

The interpretation of this particular code is not always clear. If an investment does not involve the use of interest, benefits society, and otherwise conforms to the teaching of Islam, then Islamic investing is something that might be considered acceptable. It fails to meet all of the above-mentioned criteria, then trading actions might face further scrutiny. 

Justification for Islamic Banking 

The Islamic banking system is rooted in the original teachings of Muhammad. This system makes it possible for Muslims to access capital without sacrificing their values. 

Ultimately, the underlying driver behind the entire Islamic banking system is “Justice.” The traditional banking system, particularly due to the widespread use of usury, is something that is both fundamentally and ethically unacceptable to most Muslims. Justice, as defined by Socrates, is the “greatest virtue of the soul.” In other words, for both Muslims and non-Muslims, any deviation from the pursuit of Justice ought to be considered a corruption of the soul. 

As a result, it is easy to justify the existence of Islamic banking. There are at least a dozen references throughout the Quran that clearly indicate the harms of usury and why the use of usury should be avoided by all people. The collection of interest—despite the short-term benefits that this commonly used system might provide—is something that can lead to a variety of social problems. The use of an unethical system in order to deliver short-term benefits ought to be recognized as simply unacceptable. 

So, while the foundation of Islamic banking is rooted in the direct words of the Prophet Muhammad, it is also clear that the underlying principles affecting this system extend far beyond that. Regardless of a person’s particular religion or general belief system, anyone who objects to exploitation, inequality, and the misuse of the entire money system ought to also object to the status quo and pursue an alternative system instead. 

This is the foundation of Islamic finance. It is not rooted in obscure interpretations of the Quran, extremism, or anything of the sort. It is rooted in the natural human condition—and every Muslim ought to maintain the right to pursue their long-term financial dreams without ever having to abandon their underlying set of beliefs. 

Muslims—especially in the Western World—have a unique set of obligations. Contrary to many of their counterparts, they cannot simply apply for an interest-bearing loan and call it a day. But they also need to find sources of financing that can simultaneously fit their ethical needs and their current budget. 

Fortunately, there are many financing options that are specifically designed to meet the needs of American Muslims (among others). At Guidance Residential, we are committed to providing a faith-friendly alternative to a traditional riba-based mortgage.  

>> Have more questions about Islamic finance? Call 1.866.GUIDANCE or connect with us today to see how Guidance can help you finance your dreams.