Why do Muslims forbid Interest based transaction? And how do we understand Islamic economics without interest? How does Islamic Banking work?
Muslim economists view money as something to be earned, which is one of the many reasons that both gambling and most forms of loaning at interest are prohibited. While there are different types of interest and not all types are viewed as being the same, many Muslim scholars regard interest as generally prohibited because it penalizes the poor for their lack of money and rewards the rich for their abundance of money, making the rich richer and the poor poorer.
On the other hand, investment in business is highly encouraged because it involves some risk to the investor, which makes it a fair return. Investment also promotes the circulation of wealth and the growth of new businesses.
Applying this principle in the modern world is a major challenge, yet today there are over five hundred financial institutions offering Islamic finance in over eighty different countries. These institutions generate income through shareholding, leasing, lease purchasing, and rent sharing. Interest-free banking is an experiment in Islamic modernization.
The fact that Islamic banks are now worth a trillion dollars attests to their modern viability. In fact, many western economists maintain that interest-free economies can be extremely beneficial. An example of this is the growing popularity of interest-free financing in auto sales in the U.S. today as a means of attracting less affluent customers.
Additionally, many economists have noted that during the recent financial crisis Islamic investments and banks were largely unaffected, since they did not deal with interest based financing such as mortgages or risky speculation.