Imagine your savings keeps growing year after year, not just through simple interest, but through a financial concept called compound interest. This concept enables you to profit not merely on your initial investment, but also grow on the interest you’ve earned in the past.
In Islamic finance, this financial concept raises questions about its compatibility with religious principles. The key question many ponder is, “Is compound interest haram?”
What is compound interest?
Compound interest is an investment method where profits accumulate not only on the initial amount (the principal) invested but also on the interest earned in previous periods. This leads to exponential growth as interest builds on both the principal and earlier interest.
Apart from being an investment tool, it can also manifest as Riba al-Nasi’ah. In this form, interest isn’t calculated solely based on the initial amount borrowed; it also accumulates on any previously earned interest that remains unpaid.
For instance, $100 would grow annually if you kept it in a savings account with a 5% annual interest rate. You gain $5 in interest in the first year, increasing your total to $105. You earn $5.25 in interest in the second year on a new principal of $105, bringing your total to $110.25. You receive $5.51 in interest on the new principal of $110.25 in the third year, bringing your total to $115.76.
Initial Investment (Year 1)
- You open a savings account with a $100 initial deposit.
- The account offers a 5% annual interest rate, so you will earn $5 in interest on your initial deposit in the first year.
- Your total sum at the end of the first year will be your initial deposit plus interest: $100 in principal + $5 in interest = $105.
Year 2
- In the second year, your principal is now $105 because the interest from the first year was added to it.
- You earn 5% interest on this new principal, which is 5% of $105, equal to $5.25.
- So, at the end of the second year, your total balance is $105 (principal from year 1) + $5.25 (interest from year 2) = $110.25.
Year 3
- In the third year, your principal is $110.25.
- You earn 5% interest on this new principal, which is 5% of $110.25, equal to $5.51.
- At the end of the third year, your total balance is $110.25 (principal from year 2) + $5.51 (interest from year 3) = $115.76.
Continued Growth
- This process continues each year, with your money’s growth based on the interest earned in the previous year.
- Year after year, your money continues to grow at a slightly higher amount as the principal increases due to the added interest.
It is worth noting that compound interest differs from simple interest. In a simple interest system, interest is applied only to the initial amount borrowed or invested and does not accumulate over time. As a result, the total amount owed or earned remains relatively constant throughout the transaction.
Is Compound interest haram?
In the Quran, Allah forbids all forms of interest. In Surah Al Imran, verse 130, Allah emphatically addresses compound interest.
يَـٰٓأَيُّهَا ٱلَّذِينَ ءَامَنُوا۟ لَا تَأْكُلُوا۟ ٱلرِّبَوٰٓا۟ أَضْعَـٰفًۭا مُّضَـٰعَفَةًۭ ۖ وَٱتَّقُوا۟ ٱللَّهَ لَعَلَّكُمْ تُفْلِحُونَ
Translation: ‘O believers! Do not consume interest, multiplying it many times over. And be mindful of Allah, so you may prosper.’
Even in Surah Al-Baqarah verse 275 in the Holy Qur’an, it is stated that those who persist in usury, known as riba or interest, despite its prohibition, are essentially waging a war against Allah Ta’ala and His Messenger. Their ultimate destiny is the eternal fires of judgment day
ٱلَّذِينَ يَأْكُلُونَ ٱلرِّبَوٰا۟ لَا يَقُومُونَ إِلَّا كَمَا يَقُومُ ٱلَّذِى يَتَخَبَّطُهُ ٱلشَّيْطَـٰنُ مِنَ ٱلْمَسِّ ۚ ذَٰلِكَ بِأَنَّهُمْ قَالُوٓا۟ إِنَّمَا ٱلْبَيْعُ مِثْلُ ٱلرِّبَوٰا۟ ۗ وَأَحَلَّ ٱللَّهُ ٱلْبَيْعَ وَحَرَّمَ ٱلرِّبَوٰا۟ ۚ فَمَن جَآءَهُۥ مَوْعِظَةٌۭ مِّن رَّبِّهِۦ فَٱنتَهَىٰ فَلَهُۥ مَا سَلَفَ وَأَمْرُهُۥٓ إِلَى ٱللَّهِ ۖ وَمَنْ عَادَ فَأُو۟لَـٰٓئِكَ أَصْحَـٰبُ ٱلنَّارِ ۖ هُمْ فِيهَا خَـٰلِدُونَ
Translation: ‘Those who consume interest will stand ˹on Judgment Day˺ like those driven to madness by Satan’s touch. That is because they say, “Trade is no different than interest.” But Allah has permitted trading and forbidden interest. Whoever refrains—after having received warning from their Lord—may keep their previous gains, and their case is left to Allah. As for those who persist, it is they who will be the residents of the Fire. They will be there forever.’
Based on the verses cited above, it is evident that compound interest is considered haram (forbidden). Halal (permissible) alternatives to conventional compound interest-based financial activities are offered by Islamic financial institutions and include methods such as Murabaha, Mudarabah, Musharakah, and Ijarah. We will provide a detailed explanation of these halal alternatives as we progress further in this article.
In addition, compound interest is seen as a tool of economic exploitation in Islamic economics for several reasons, which are:
- A means of exploiting others to make a lot of profit through interest
- It results in a scenario where wealthy individuals become even richer, while those who are already poor become even poorer. This can often lead to societal issues, which contradict the principles outlined in the Holy Qur’an (Surah Hashr:7). This verse emphasizes the fair distribution of wealth to aid those in need and discourages the concentration of wealth among the affluent.
- It leads to a constant rise in product prices due to interest being added to production costs, transportation, duties, and expected profits.
Halal Alternatives to Compound Interest
Several Islamic alternative forms of investment align with Islamic finance principles for Muslim investors and institutions. Some of these are explained below:
Murabaha (cost-plus financing)
Murabaha can be regarded as cost-plus financing. This arrangement enables individuals and businesses to acquire valuable assets such as vehicles, real estate, and equipment without relying on conventional interest-based loans. In this process, a prospective buyer selects a specific product or property. A financier then acquires the chosen item, assuming ownership until the buyer completes payment. The final payment includes both the item’s cost and an agreed-upon profit margin, which can be settled in full or through installments over a predetermined period.
Mudarabah
This involves a partnership between two parties: one party provides funds (known as the ‘Rab-ul-Maal’), while the other contributes management and expertise (known as the ‘Mudarib’). This arrangement fosters risk-sharing, entrepreneurship, and fairness in financial transactions, aligning with Islamic finance principles.
Musharakah
Musharakah is a form of partnership where two or more parties come together to invest their money and skills into a venture. When the venture makes a profit, the parties share it according to their agreed-upon ratio. If the venture faces losses, they also share those losses based on the amount of money they initially invested. It’s a way for people with different resources to collaborate fairly when starting a business.
Ijarah
Ijarah is a lease-based financing arrangement where the owner (lessor) leases an asset to the user (lessee) for a defined period. The lessee pays rent, which includes the asset’s cost and profit.
Conclusion
In conclusion, the question “Is compound interest haram?” finds a clear answer in Islamic teachings. Based on the Quranic verses provided, compound interest is indeed considered haram, or forbidden. The verses emphasize the prohibition of interest (riba) in any form, which includes compound interest. Islamic finance offers halal (permissible) alternatives to conventional compound interest-based financial activities, such as Murabaha, Mudarabah, Musharakah, and Ijarah.
These alternatives promote ethical and fair financial practices in line with Islamic principles, discouraging economic exploitation and wealth concentration. For example, Murabaha allows individuals and businesses to acquire assets without relying on interest-based loans; Mudarabah fosters risk-sharing and entrepreneurship; Musharakah promotes fair collaboration when starting a business; and Ijarah provides a lease-based financing option.
In essence, Islamic finance offers ethical and permissible alternatives to compound interest, providing a framework for financial transactions that align with Islamic principles of fairness and justice.