Loan and Debt in Islamic Banking

The Arabic Qard and Dayn usually translate to “loan” and “debt” in English, however, these terms are also used interchangeably. The Islamic banks follow the Shari’ah definition which stipulates Qard to be a loan via lending of money which requires it to be repaid, and Dayn is a debt obligation on one party arising out of any transaction which may be either for sale or rental of goods or services.

Since interest is forbidden in Islam, the borrower has to pay only the principal amount of loan with no addition for interest. Although banks generate profit through various income generating transactions without involving interest, they can only provide Qard as cash for cash basis which is referred to as “Qard Hasan” in Shari’ah. Since the banks cannot make profit from these loans, they may provide Qard as a social service to needy individuals or only to those who are bank customers and have a financial relationship with the bank.

Qard is a direct transfer of asset or cash from the lender to the borrower with the conditions that the same will be returned back to the lender. It is not a byproduct of a business transaction, sale, trade, or rental. Qard transaction may involve non-Muslims, employers, employees, governments, or any other real or business entity. No addition is allowed in repayment of loan. Qard is only for the benefit of the borrower and the bank is not expected to generate any profit or material gain from the transaction. Some banks charge a service charge for the loan processing. The charge should not be tied to the amount borrowed but rather represent the actual administrative expenses of the bank.

Current accounts with Islamic banks are considered loans to the bank as no gain is expected from these loans by the customer. The bank is obligated to pay back the requested amount on demand. The customer gives the bank the right to use this money for making profit but does not expect anything in return except a safe place to hold his or her money. Some scholars have allowed gifts to the current account holders as long as they are not guaranteed or fixed. This view is not universally accepted though.

Dayn is any debt obligation that may result from a transaction of trade or rental. In Islamic banking, usually it would be through a for profit contract that a bank customer may carry out with the bank which results in him or her owing something to the bank. The profit or gain from the transaction would be part of the debt obligation as a whole and cannot be added to the transaction as that would be tantamount to forbidden interest.

Dayn may be also the product to be delivered later due to a salam transaction where the payment is paid in advance. Similarly, an istisna’a transaction also generates debt obligation for the payment amount or series of payment against whole or series of deliveries. Conversely, dayn could be the deferred payment due to a bai mu’ajjaltransaction where the product is delivered for later payments. Dayn is also an obligation of payment or payments against a lease agreement for the right to use certain product for fee.

Allah SWT orders Muslims “O ye who believe! fulfill (all) obligations” Quran (5:1). Repayment of loans and debts are moral obligations that all Muslims must abide by. In case one has genuine difficulty in paying back the obligation, shari’ah allows rescheduling, postponement, or complete annulment of the loan or debt according to the consent of the contracting parties.

The prohibition of interest implies that the lender would not ask for any increase in the amount of loan or debt due to the time delay in payment. The delay could be due to some difficult circumstances or voluntary. Since the latter situation is prone to abuse and could result in malfunctioning of the financial economy, the scholars have allowed legal action against the defaulting party. Any settlement earned by the lender in this case cannot be treated as profit and has to be donated to charity. This ruling forces the borrower to abide by the contract while compelling the lender to be more vigilant in evaluating the credit worthiness of the borrower.

The borrower shall have full intention of paying back the loan or debt amount as per the agreement. The non-payment of loan without a valid excuse is considered a sin and an injustice. The Shari’ah allows punishment for default of the loan in this case and also commands the borrower to show his appreciation to the lender when paying back the loan. There is some difference of opinion among different Fiqh schools of thought about the question that the lender could demand early payment of loan from the debtor. Any delay in payment should be discussed and agreed between the contracting parties.

Some Islamic banks do include a clause of late payment charges and treat that amount as profit for the bank. They justify it based on the fact that the money that was delayed could have been used by the bank to earn more profit from other transactions. In case of complete default the bank can use the proceeds from the legal action to cover any real, tangible losses from non-payment of loans. However, in either case, the Islamic banks must be careful to assure that they are not merely earning interest from late charges and actually covering their losses.
Similarly, the question of rebates or early payment discount also raises the issue of interest. In conventional loans, the borrower can usually pay off the principle of the loan any time he is able to, as long as that is allowed in the contract. The money saved is the interest that he did not have to pay. Most Shari’ah scholars do not allow for such discounts as that would be interest. In Islam, cash or credit price is fixed at the time of transaction and that price must be paid in full regardless of time. This though is a genuine need of time as the situation of the borrower can change and he should be able to make early payment and get compensated for that. The Shari’ah scholars have allowed such rebates at the discretion of the bank at the time of early payment. The rebates cannot be predetermined in the contract.