“Difference between Interests based loans and Non Interest loans”

This article is an excerpt of a lecture delivered by Mr Sarfarazuddin who is a young scholar and activist based in Patna. He was invited by the Forum of Group Discussion on Economic Issues (FGDEI), Patna. The programme was held on 21st April 2018 Sahulat Micro-Finance Society, Patna.

Interest, in finance and economics, is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. To know more about the interest and its ill effects and alternative of interest one must go through the following concept including History of Interest, History of Money, History of Banks, and Methods & process of Interest calculation in Bank & Non-Interest based Loan Products.

History of Interest

Interest was in practice from the time of Mesopotamian civilization. In 3000 B.C. commodity money such as cow was used for transactions. In 1900-2000 B.C. usury (interest) was prohibited by the rulers around Egypt. Later on, followers of Judaism started usury (interest) practice. But again after some years, it was banned with a rider which permitted usuary when Jews were doing business with any other community. Similarly, in the beginning, Christians were also against interest practice but later on, it became soft on the issue and interest system started operating in the society.

Islam has a strong sanction against usury and in the areas under its control rulers strictly stopped interest-based transactions. During the crusade era, interest practice was again spread in the Christian world. In the 10th century with the rise of protestant Christian, interest practice got a significant boost.

History of Money

To understand the economy one should know the history of money. Since 5000 B.C. barter system was in practice. But it had a problem of double coincidence. Around that period cattle were used as commodity money. In 1000 B.C. seashells were used as a medium of exchange. But these were not practised widely.

In 500 B.C. Coinage system was introduced which proved very much convenient in trade transactions. To boost trading banks were opened. Later, the Roman Empire helped very much in the spread of money. They developed banks and improved economic principles which spread in the world.

During the medieval period travelling traders from China, India and some parts of Arab were carrying their merchandise to Europe through silk routes. To facilitate the business of these travelling traders, merchant banking was started in 1200 A.D. They used traveller cheques type instrument for their trade practices. All this system of the transaction was interest-based.

Interest charged in Banks

In the current banking system, banks pay interest on deposits and charge interest on loans. Since loans are given on a higher rate of interest than the interest paid on deposits, the difference between the two is the bank’s profit.

In 1770 the banking system was introduced first time in Bengal in India. In 1806 Imperial bank was opened (which is now known as State Bank of India). The main objective of banks in those days was to help the trader’s community. Accepting deposits was a very small portfolio of bank transactions.

Charging of Interest by a bank – Factors considered by banks for charging interest to borrowers are interest on deposit + overhead cost + administrative cost.

Prior to 1991 RBI was issuing guidelines for paying & charging interest and fixing minimum and maximum criteria. After 1991 (Economic Reforms) interest charging system was changed and it was deregulated. From 1994 to 2003 Prime Lending Rate (PLR) & BPLR system was introduced. After 2003 it changed to Base Rate system. From 2016 to till date Marginal Cost Based Lending Rate (MCLR) system is prevailing.

A RBI study, in 2017, found that banks are fixing the rate of interest very arbitrary to earn a profit. This is due to their bad debts, with a view to minimize their loss. Their system of charging interest is not transparent.

Effects of interest rates on macroeconomic issues

After 1947 bank rates, policy rates (repo rate, reverse repo rate) were practised to regulate commercial bank interest rates. Beside that open market, operations have also an effect in setting the interest rate. Money is supplied to open market and its price fluctuates up & down depending on demand. Thus it affects interest rate in India.

Suppose the interest rate is left unchecked in the market it can bring devastating changes in the macroeconomic parameters of a country. Moreover, if interest is clubbed with the idea of the rate of inflation, then it opens up its more lethal claws.

The book “Theory of Interest” which was written by renowned economist Irving Fisher published in 1930, discusses how interest rate controls the money supply in the market. Mr Fisher in his book has given equitation “Real interest rate = Nominal interest rate – Inflation” (r = i – π). The rate at which banks are lending to borrowers is the nominal interest rate. If inflation is deducted from the nominal rate it will become a real interest rate. If the rate of inflation is high then the real interest rate will become small. Thus a situation may come where the interest rate will become negative.

After America’s great Economic Depression (1929 to 1933) John Maynard Keynes has published a book namely “General Theory of Interest and Employment” (1936). He explained how interest affects the supply of money. In the short term, the interest rate in the market is to be controlled by the govt., otherwise, its effect will be very exploitative and damaging.

Non–Interest Based Loans

There are three types of Non-Interest based loans which are given below

i) Profit and Loss Sharing Loans,
ii) Exchange Based Loans, and
iii) Service Charge Based Loans.

On the principle of profit & loss sharing concept, many instruments have been developed by different banks globally, particularly in England, Malaysia and some Arab Countries. Many new banks in the world are in the process of adopting these principles. After 1970 following products were developed by the Islamic World – Musharaka, Modarbah.

In Musharakah both partners have to co-share their capital, time and labour. But in Modarbah one partner will provide only her capital and the other partner will contribute her time & labour. Profit & Loss will be shared on their mutually agreed terms.

In the above-mentioned system trade and business, the cycle is not very much affected by trend and changes in the market. In case of shrinking of business of a borrower, the repayment period can be extended. Thus the risk of loss can be minimized. But in capitalist economy trends and changes adversely affect the business cycle.

Exchange-based loans which are not based on profit & loss sharing concept has not got momentum as not many instruments (of exchange based loan system) have been developed till date. Some instruments are available in a few Islamic countries. One popular product is Morabaha which is the most secured and hassle-free loan product. Under this scheme, goods are purchased and handed over to member by adding some markup price. Repayment of loan comes within a fixed period in Equated Monthly Installments (EMI).

Besides these other Investment & Insurance product are also being formulated.

The interest-free economic system can’t challenge existing capitalist system because the former is in research and development stage whereas the latter is well established in the world albeit, the main demerits of Capitalists economic system are interest, uncertainty and speculation. The interest-free system helps in curbing the above demerits because it is less affected by market conditions and inflations. Countries like Malaysia, Iran & Pakistan are working to develop more interest-free products to curb the menace of interest, uncertainty and speculation.

The service charge based loan products is easy & hassle-free. Service charge is decided on the basis of Marginal Revenue + Marginal Cost. Its effect is free of market changes. Though this product is interest-free but not cost-free hence a reasonable service charge is collected from the borrower. Service charge is debited instantly at the time of disbursement of the loan.

But still, there are miles to go, researches & studies are going on to develop more products based on Non – interest to compete in the economic market.