Concept of Time Value of Money in Islamic Economics

Islam does not allow riba on loans. The interest is provided to the creditor for the opportunity cost he may lose because of lending money. According to Shariah scholars, the interest rate set by the creditor is certain where is the profit or loses to the lender are uncertain. To take profit as a compensation for the uncertain situation of the future is tantamount to indulging in riba and is consider as unlawful by the Shariah scholars. For example a loan is provided by the creditor to the lender for performing some economic activity. The lender is obviously opting for profit but the fact cannot be neglected that he may have loses in performing economic activity. In this case, either he have gain or lose he must have to pay interest to the creditor. The lender considers Future Time Preference (FTP) before providing loan. As he is uncertain about future and feels 1 dollar today will not be of the same worth by tomorrow. Hence the lender includes four things in the profit rate .i.e. interest rate, operation/transaction cost, inflation premium and risk premium. Islam on the other hand does only accept profit rate and transaction cost whereas the inflation and risk premium are unlawful as Islam does not believe in opportunity costs and risks of future. Shariah scholars believe that Islam is not against Future Time Preference. The Prophet S.A.W said that Virtuous are they who pay back their debts well. From this Hadith it can be concluded that lender may give hibah to the creditor as a token of appreciation to the creditor as the creditor forgone his current consumption for the sake of helping him. In Islamic economics the loan is provided as Qard. The lender is fully allowed to use it for any purpose as long as the performed activity is under Shariah principles. In Qard principle, the lender may give some extra money to the creditor as a token of appreciation. The difference can be seen in conventional loan and the Islamic loan principle as in conventional loan, interest rate or profit rate is set by the creditor whereas in Qard principle the profit is set by the lender. Shariah scholars agreed on the fact that the price of the commodity sold on credit can be higher as long as both parties are willing. The credit price is higher because of the risk of ownership associated with the commodity due to market forces. Once the commodity becomes the property of lender and he has to pay the instalments that include profit rate +

Operational costs only. The creditor does not have the right to increase the instalment rate by re-pricing the commodity because that commodity is no longer creditors property. On the contrary side as discussed earlier that conventional banks includes four things in the instalment rate i.e. interest rate, operation/transaction cost, inflation premium and risk premium. The inflation premium gives birth to time value of money and due to this the instalments are calculated on compounding interest basis. Hence the customer has to pay the interest in compounding manner. It means that the principle amount of the commodity is re-priced by the bank after every instalment which is unlawful according to Islam. Conclusion: Shariah scholars do accept the principle of time value of money in sale contracts because the price of the commodity fluctuates due to market forces of demand and supply. Hence it is allowable to have increase in the credit price of the commodity. But they do not allow time value over loans provided to the lender. Creditor is not allowed to set the interest rate over the loan as the future investment of such loan is uncertain i.e. either it will be a gain or loss to the lender by investing the money in future. Shariah scholars are also against the inflation and risk premiums as these premiums falls under the opportunity cost concept and Islam does not accept the principle of opportunity costs.