Interest And Inflation
WHAT ARE INTEREST RATES?
Interest and inflation rates are linked and affect our daily lives from the cost of our weekly shop to how much money we can borrow. Interest rates are essentially the amount borrowers are charged for borrowing money. Most banks will show the interest rate as a percentage of the total loan amount. This means that the higher the percentage, the more interest you will pay back over the term of your loan.
If you are not a borrower and you are a saver, then the interest rate will inform you how much money you will accrue in your account. the higher the interest savings rate you have the more money you will be paid into your bank account.
Interest rates vary depending on who you are borrowing from, the amount of your borrowing, the level of risk involved, and the terms of your loan.
If a lender thinks lending you money is high-risk then it is likely they will charge you a higher interest rate. In this way, the economics of a country are impacted by the interest rates.
HOW CHANGES IN THE INTEREST RATE AFFECT US?
One of the most obvious impacts of a changing interest rate is that it affects the amount of interest we are paid (as savers) or pay (as borrowers).
Any time there are changes in interest rates you should examine your savings and lending to see if you will be affected.
For those looking to borrow money, whether that is to buy a house, invest in business, or even just for the purposes of education (such as a student loan), the cost of borrowing will increase when interest rates are raised.
Current economic uncertainty means that businesses, individuals, corporations, and almost everyone in society are impacted.
For homeowners, an increase in interest rates means an increase in repayments (unless the mortgage is based on a fixed rate). Ultimately, this will result in a squeeze on household income and budgets at a time when the UK is dealing with an energy bills crisis and an increase in fuel costs.
To summarize the main effects of rising interest rates:
- increase in mortgage repayments
- increase in the cost of borrowing
- reduced consumer and business confidence
- increased incentive to save more to take advantage of the improved interest rates (but this depends on the rate being offered by banks on savings accounts)
- slower economic growth
- possible rise in unemployment
WHAT IS A BANK RATE?
A bank rate is set by the Bank of England. Arguably, it is the most crucial interest rate and is also sometimes known as the base rate.
The base rate is controlled by the Bank of England and is the rate paid by the Bank of England to businesses and banks that borrow from it.
The Bank of England is known as the central bank of the United Kingdom. They not only set the bank rate, which is currently 1.25%, but they also undertake the regulation of the banking industry, and financial business services, and they oversee the country's monetary policy. This then goes on to affect the economy including employment, wages, spending, and borrowing.
When banks set an interest rate they consider many factors in addition to the bank rate.
However, if the Bank of England changes the bank rate, then banks will also change their interest rate for both borrowers and savers in the market.
WHAT IS INFLATION?
The word inflation describes rising prices. If prices of goods and services are rising quickly then this is referred to as the rate of inflation.
Currently, in the United Kingdom the rate of inflation is 9.4%.
The rate of inflation is worked out by comparing the cost of products today and comparing the price against what the same products cost a year ago. The Office for National Statistics is the organization that is responsible for checking the price of goods and services.
If the price of production, imports, and raw materials increases then it is very likely that the rate of inflation will also increase. In addition, any increase in demand from consumers also causes the inflation rate to increase.
This is what is currently happening in the UK with the cost of living crisis.
WHAT CAUSES INFLATION?
As mentioned above, inflation is caused by various factors. The main drivers of inflation rates going up are the increased cost of production, and increases in raw materials and wages.
If inflation rates begin to increase it means that the cost of basic necessities including food and household items also rises. This can adversely affect society as many people will struggle to afford the basics and fall into debt. Inflation rates could also affect employment rates as employers also face cuts to their budgets and increased costs of operating.
Inflation does not only affect the basic necessities such as food. As we have seen recently in the UK, inflation also affects utilities, fuel costs, clothing, luxury goods, and cars.
Some of the main factors causing the rising prices in the UK, and thereby affecting the rate of inflation, include the following:
- increase in energy bills
- high fuel prices
- the war in Ukraine
- the rising cost of car prices (according to the Office for National Statistics)
- increased costs of household goods and furniture
- increased costs of food
- higher interest rates impacting homeowners
Whilst the cost of goods is rising, the wage increases are not rising in line with the cost of living.
HOW ARE INTEREST RATES AND INFLATION CONNECTED?
Theoretically, interest rates and inflation rates have what is considered to be an inverse relationship. This means that when interest rates are low, inflation is expected to rise, and when interest rates are high inflation rates should go down.
When interest rates are lower, the borrowing power of consumers is increased.
If consumers are spending but the prices of goods are going up faster than wages are increasing, then inflation rates increase. In order to encourage borrowers to borrow less and encourage them to save more the Bank of England increased the interest rate.
The aim is to slow the economy down enough to decrease inflation.
WHY HAVE INTEREST RATES GONE UP?
The Bank of England has increased interest rates so that it can reduce the rate of inflation. If the rate of inflation continues to go up in the UK then this can have many negative effects on UK residents. Currently, the inflation rate in the UK is at a 40 year high.
For example, people will have to pay more and more for goods and services. Property could lose some of its value, and fuel prices could continue to rise.
If inflation rises too high then this is called hyperinflation. This can result in a full economic collapse and devalue the currency.
WHY DID THE BANK OF ENGLAND RAISE INTEREST RATES?
The general view is that if the Bank of England raises interest rates they want people to spend less money.
When interest rates increase the Bank of England hopes that people begin to spend less and save more.
The Role Of The Bank Of England In The Economy
The Bank of England was established in 1694 as a private bank that lent the UK government money.
In 1997, the Bank of England was granted independence so that it could set the interest rates without any form of political affiliation.
The Bank of England is not connected to the Chancellor of the Exchequer as it it is important for it to base its interest rates on economic factors rather than political ones.
Not only does the Bank of England set the base rate, but they also:
- forecast the inflation rates
- issue coins and bank notes
- act as a lender of last resort for UK banks
The Current State Of The Uk Economy
According to PWC, the UK economy was recovering well from the global pandemic.
Unemployment rates were low and the labour market and service industry was recovering well.
However, the war in Ukraine was a shock to the UK economy (and economics globally), impacting it in many different ways including:
- disrupting supplies and services for all industries including retail and construction,
- leading to higher commodity prices and less revenue for businesses
- lower trade levels
- less investment flow
News agencies and websites are reporting that the UK growth outlook for the next 12 months does not look promising.
KPMG has agreed with this analysis stating that the GDP growth this year will halve and slow further in 2023 (UK Economic Outlook Report, KPMG, 2022).
According to KPMG, they predict further interest rate increases from the Bank of England. This is based on data from economic forecasts, consumer spending, interest rates, and the unemployment rates.
WHAT IS HAPPENING IN OTHER COUNTRIES?
Many other countries around the world are dealing with similar problems that the UK economy is dealing with.
According to the Office for National Statistics, the European Union is facing similar rates of inflation as the UK.
The United States is reporting inflation levels of 9.1%.
DO INTEREST RATE AND INFLATION RISES AFFECT INVESTOR BEHAVIOR?
The basic answer to this question is yes. Interest rates and inflation rates affect investor behavior. In fact, changes in inflation and interest rates affect everyone.
What it means in real terms is that any money you have saved could be worth less today than it was yesterday. High inflation rates impact the purchasing power and confidence of consumers and their spending.
Inflation rates and interest rates affect investment portfolios. If investors are finding it more expensive to borrow funds to invest then it is very likely that investments overall will reduce.
Investor Risk
Investors aim to increase their wealth and minimize their risk and tax liabilities. In an economy where interest rates and inflation are rising, there is normally an impact on portfolios and investments.
Rising inflation not only affects stocks and bonds it also affects property prices. Of course, all investment comes with a risk of losses.
Any investor with inflation-indexed assets or liabilities needs to be particularly aware of the changes in their portfolio.
Also, as interest rates rise this affects borrowing. As borrowing becomes more expensive, this leads to investors having less money available to invest.
Rises in interest rates also affect the stock market and the impact of the rise is usually felt quicker than in the general economy.
Normally, when interest rates fluctuate investors should expect the market rate of their bonds to also fluctuate. However, not all bonds are equally affected. Bonds that have short maturities may not be as impacted as bonds with longer maturities.
For investors who have a long-term outlook and planning when it comes to their portfolio, short-term changes to the interest rate should not significantly impact them.
For an investor who is looking at the long-term goal and who has a mix of assets, the long-term outlook of their portfolio should be fine.
To summarize, when interest rates increase the impact on investments includes the following:
- a rise in mortgage rates
- affect on the price of commodities
- Fall in bond prices
- Potential losses in the stock market
- fluctuations in real estate values
- increases competition between banks
Interest Rates And Islamic Finance Customers
For many borrowers, any increase in interest rates will affect how much they pay back to the bank they have borrowed from. The exception to this is those with fixed rate loans or mortgages. As the interest rate on these loans has effectively been 'fixed' for a specific period, then interest hikes or drops will not affect the repayments. Make sure to check when your fixed rate period comes to an end so you can plan accordingly.
In theory, for customers of banks who want Islamic Finance and Sharia compliant services, changes in the interest rate should not adversely affect borrowers or savers. This is because banking services based on Islamic Finance principles do not rely on interest or include any form of interest payment.
Conceptually, Islamic banking customers are not motivated by profits or gains. Therefore, changes to the interest rate should not affect them.
However, on a wider scale, any changes to the interest rates and inflation will affect all lending institutions in some way. Many Islamic Finance lenders use the base rate of the country to benchmark their repayment calculations. This means any increase to the base rate could affect the repayments for customers of Islamic finance products.
However, for economies where the interest and inflation rates and subject to fluctuation, this could lead to more people being interested in the interest-free products offered by financial institutions that offer Sharia compliant services. A research study in Malaysia found that any increase in base rates increased consumer interest in Islamic mortgages.
Ultimately, how you are affected by increased interest rates and inflation rates depends entirely on your financial circumstances and the management of your investment portfolio.
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What Is The Recovery Loan Scheme
The Recovery Loan scheme was launched on the 6th April 2021 by the UK government as a successor to the government’s Interruptions Loan Scheme and bounce back grants from 2020. As with any loan scheme, this scheme requires the payment of interest. This, of course, is contrary to Islamic Sharia law principles that forbid the collection or payment of interest.
For many Muslim-owned and backed businesses, the question has arisen as to whether the Recovery Loan Scheme is Sharia-compliant. Before we address that, we need to look at the Recovery Loan Scheme and its key features.
The Recovery Loan Scheme provisions were put in place by the government to ensure that they were able to provide financial support to UK businesses. The government wanted to offer additional funding to businesses in the UK that needed the funding to survive the economic turmoil brought on by the pandemic.
The Recovery Loan Scheme’s main purpose is to facilitate recovery and growth post-pandemic. The payments from the Recovery Loan Scheme also aim to ensure that businesses survive during the transitional period back to regular business activities.
The scheme is open to any business that is:
- Trading in the UK
- Able to show it has been adversely affected by the pandemic
- Not involved in any insolvency proceedings
- A viable business if not for the pandemic
How The Recovery Loan Scheme Works
The Recovery Loan Scheme wants to facilitate a full return to business activities for those businesses that have been impacted by the pandemic. The successive lockdowns have affected many small and medium businesses that have been unable to earn an income from their trade.
The Scheme is targeted at businesses that are viable enough to afford debt finance. The British Business Bank administers the Scheme. The actual funding is made available via a range of accredited lenders.
As with any process that involves applying for a loan, businesses need to make a formal application via the lender of their choice.
The loan consists of standard commercial lending terms and this includes the payment of interest on the loan amount. The interest rate varies depending on the lender who provides the loan.
Features Of The Recovery Loan Scheme
An approved lender of the Scheme can provide various loan products including:
- Overdraft facilities
- Asset finance monies
- Term loans
- Interest and fees payments
Any business applying for a loan through the Scheme can borrow up to £10 million. There are also minimum facilities that start in the sum of £1,000.
Some other key features are:
- Guarantee: the government itself guarantees up to 80% of the loan to the lender, irrespective of the size of the loan. This guarantee is not provided to the business, but direct to the lender.
- Interest: any business that takes out a Recovery Scheme Loan will have to make interest and fees payments from the date the loan is drawn. Although interest rates are capped at 14.99%, lenders are encouraged to keep the rates low.
- Term: terms vary from 3 months to 6 years.
What Are The Sharia Rules Relating To Loans And Interest
Sharia law prohibits businesses from paying or receiving interest. Interest, known as riba in Sharia law, is forbidden as it is seen as a mechanism that promotes social injustice. One of the central concepts of Islamic Finance is that Muslims cannot benefit from lending money and paying interest on loans.Sharia law deems riba as an exchange with no equity. That means that it encourages an exchange that is considered to be unequal and unjust. Riba is considered to be an exploitative transaction.
Bottom Line
If we have a look at the Recovery Loan Scheme, it relies on interest payments as a key feature of the Scheme’s repayment terms. The interest element of the Scheme deems it to be non-compliant with Sharia law. In this case, the business will be repaying the full loan amount plus interest at a rate decided on by the lender.
The Scheme goes against the Sharia principle of ensuring investments and payments are socially responsible.
Sharia law clearly states that lending with the payment of interest favours lenders who make money at the expense of the borrower. Islam forbids the receipt of income from money alone, and this is precisely what interest payments are.
Islamic Finance is based on ethical economic principles. The Recovery Loan Scheme is therefore not Sharia-compliant as the interest payment element of the Scheme is contrary to Sharia principles.However, businesses that operate within Islamic Finance principles can still recover from the pandemic. Islamic Finance is focused on sustainable economics and there are products available within the Islamic Finance market that can assist businesses with economic recovery.
The Qardus Option For Business Funding
We provide finance to small and medium-sized enterprises with growth potential that the business owners want to unlock. The funding available is from £50k to £200k with terms of between 6 and 36 months.
Our funding process is rooted in Islamic community principles and is certified as Sharia-compliant. As a result, we don't charge interest and we don't work in business sectors considered damaging to society, such as alcohol, tobacco or gambling.
Because of our principles, our funding solution is an attractive option for Muslim business owners, but we also provide funding to business owners outside the Muslim community.
We offer fast, flexible and affordable business growth funding that's firmly grounded in ethical principles.
Islamic car finance is available for Muslims wanting Sharia compliant options. What halal finance options do Muslims have and how do they work?
There is a huge array of car financing and leasing options on the market for those who do not want to buy a car outright. For Muslims, the car finance options available can be difficult to navigate, especially if they want finance and leasing options that are not in contravention of Islamic finance options.
Islamic car finance operates to enable people to use their money wisely, spread the actual cost of financing the car whilst ensuring that they do not pay interest on the finance option they have chosen. Drivers can take advantage of car finance deals whilst also adhering to Islamic Sharia rules relating to interest (the payment and receipt of which is prohibited) and speculation.
The halal car finance market is aimed at those people who want Sharia compliant finance options. Essentially, for those people who do not have the cash to buy a car outright, or those who do not want to buy a car paying cash, Islamic finance ensures that people can spread the cost of the car without breaching Sharia rules.
Islamic Finance Principles Applied To Car Finance
The main Islamic finance principles relating to car finance are:
1. Riba (Interest) - Islam prohibits the receipt or payment of interest. It is deemed to be haram. In car finance terms, this means that Muslims who want to remain Sharia compliant cannot borrow funds with an Annual Percentage Rate (APR) attached. An APR is an interest rate and is prohibited in Islam.
2. Simplicity of Contracts: Islamic Sharia principles dictate that transactions should always be honest, transparent and open. This means that if you enter into a contract for leasing a car you should make sure that there is no undue risk, speculation, or gambling involved. The contract should be fair for both parties and be simple to interpret.
Buying A Car Outright Without Car Finance
It goes without saying that buying a car outright with a cash payment is probably the best option for those wanting to remain strictly Sharia compliant. If you have savings that would cover the purchase of the car you can avoid interest payments and APR. However, not all Muslims have the option of paying cash outright for a car and this is where the market has developed to cater to the needs of those wanting Sharia compliant car finance options.
Car Finance Options - Leasing
Islam does not prohibit leasing (ijara). In fact, leasing is permissible and is compatible with Islamic finance principles. Payments for vehicles can be done via leasing contracts with car companies. Sharia does not prohibit car leasing agreements because the heart of the transaction relates to a tangible asset - the car. As long as the leasing contract sets out the terms of the lease, the details of the parties, and the payments it can be structured to be compliant with Islamic finance rules.HOW DOES HALAL CAR FINANCE WORK?
Halal car finance is actually straightforward, working on the basis of a loan being agreed between the parties. The buyer and seller in the transaction agree on the value of the car the seller is selling. The seller does not charge an interest rate for payment of the car as they would normally to make money on the finance arrangement. Instead, the seller increases the purchase price of the car to cover the interest payments they would have received. No interest is actually charged by a bank or the seller.
What this means for the buyer is that the deposit will be higher than a deposit they would pay on a non-halal car finance option, but for Muslims this is a halal way of obtaining car finance.
Halal Car Finance Options
Generally speaking, the traditional car finance options such as hire purchase agreement and personal contracts are always attached to an APR and this makes them non compliant with Sharia rules.
However, below is an example of how Islamic finance options can adapt the traditional car finance options to make them halal.
Hire Purchase Agreement (Hp)
HP financing means the buyer can spread the cost of the car over fixed monthly payments and the use of a deposit. Below is an example of an Islamic finance HP deal:
Example:
Price: £20,000
Contract Term: 12 months
APR: 6%
Total Cost to buyer: £21,200
Using an Islamic finance agreement, the seller/dealer would add the additional £1,200 to the price of the car. The buyer of the car would then pay £21,200 as fixed payments monthly for the contract term. When all the payments have been made, the buyer owns the car outright.
Personal Contract Purchase (Pcp)
PCP's are a common form of car financing option and act as a loan, with the buyer only paying off the full value of the car at the end of the contract term if they decide to keep the car. If the buyer does not pay off the full value of the car then they do not own the car at the end of the contract. PCP's usually always come with interest payments and are therefore not Sharia compliant.
However, there are sometimes some PCP finance deals available for new cars but these can be expensive and the requirements are often stringent.
Personal Contact Hire (Pch)
As PCH agreements are actually long-term hiring agreements they are normally deemed to be Sharia compliant. As you are simply renting the car from the owner or dealer you are simply paying for the use of the car for a specific duration.
Conclusion
Each contract and hire purchase agreement is different. The onus is on the customer to ensure that they have inspected the terms, and service fees of the agreement before they decide whether the option is Sharia compliant. There are various Islamic car finance options on the market these days, so it is always best to explore these options rather than using the traditional bank or dealer car finance options.
Introduction
Equity financing refers to a particular method of funding a business to sustain and grow its operations. Equity involves raising funds by issuing shares for investors. Investors who buy shares of a company become shareholders and can earn investment gains if the stock price rises in value or if the company pays a dividend. Dividends are typically cash payments as a reward to shareholders for investing in the company. Equity finance allows a company to raise these funds without borrowing from conventional banks, which typically charge interest. In equity financing, there is no promise to repay the investment like in a loan arrangement, nor is there an interest component.
Impact
Equity finance has no impact on a firm's profitability, but it can dilute existing shareholders' holdings because the company's net income is divided among a larger number of shares. This means that the overall number of shares have increased but the percentage of shares owned by a shareholder decreases. For example, let's say a company has 100 shares outstanding, and an investor owns ten shares or 10% of the company's stock. If the company issues 100 additional new shares, the investor now has 5% ownership of the company's stock since the investor owns five shares out of 200. In other words, the investor's holdings have been diluted by the newly issued shares.
Generally, equity finance has the following characteristics:
- Shareholders get a level of ownership in the company
- Shareholders do no receive any interest payments, but may receive a dividend
- The investment is generally permanent without any maturity
- Upon liquidation, shareholders through equity financing are generally last to be paid
Sources of Equity Financing
- Funds are generally raised through the following methods when financing through equity issuance:
- Personal finances / bootstrapping - most small business begins this way
- Venture capital (VC) - businesses who specialise in making investments in companies in whom they see potential
- Private investors / angel investors - like VC, but they are usually individuals rather than firms
- Family & friends - taking cash from people you know in exchange for part ownership
- Crowdfunding or equity crowdfunding - a recent method of fundraising which gives the public early or exclusive access to a product or service in exchange for up-front funds. Equity crowdfunding involves offering shares for funds at an early stage
- Government - in certain circumstances a government grant may be available for small businesses
- IPO (or initial public offering) - to float your company on a stock exchange and sell shares to the public
Shariah structures for Equity Financing
There are two famous structures in Islamic Finance which are used to establish equity financing, they are Mudaraba and Musharaka.
Mudaraba
Mudaraba refers to a relationship between an investor (Rab al maal) and an investment manager (Mudarib) to establish a profit-sharing partnership to undertake a business or investment activity. Under this structure, the Rab al maal provides the financing or funds and the Mudarib provides the professional, managerial, and technical know-how to carry out the business or manage the investment. The Mudarib must invest the funds in a Shariah compliant way. The parties share in any profits according to a pre-agreed ratio. In a Mudaraba, the Mudarib:
- Puts only its time and effort at risk and does not contribute any capital.
- Is not responsible for any losses of the venture. Losses, however, are borne entirely by the Rab al maal.
Musharaka
A Musharaka is an investment partnership or joint venture compliant with Islamic principles. In a Musharaka, the financing party and its client contribute assets (cash or property) to a joint venture and share in the profits of the joint venture in agreed percentages. The joint venture is structured so that the financing party receives its initial investment plus a return that is usually calculated by a reference to a benchmark. Losses, however, are shared in accordance with the parties' initial investment. All Musharaka parties have the right to exercise control over the joint venture but it is typically managed by the client.
Musharaka is similar to Mudaraba except that in a Mudaraba only the financing party bears the losses associated with the joint venture or partnership.
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