Question

These lenders avoid using the term "interest," but their borrowers still do pay a charge for borrowing money. This would be considered lending. ( \(\mathrm{LO} 4,8)\) a) Islamic c) fringe b) payday d) subprime

Short answer

Islamic Lending is a form of lending that does not involve charging interest, in alignment with Islamic law's prohibition of usury (riba). Instead, lenders and borrowers enter into partnerships or joint ventures where profits and losses are shared. Sometimes, they engage in sale and leaseback agreements. So while no interest is charged, the cost of borrowing is included in other ways.

Step-by-step solution

a) Islamic Lending

Islamic Lending is a form of lending that does not involve charging interest, in alignment with Islamic law's prohibition of usury (riba). Instead, lenders and borrowers enter into partnerships or joint ventures where profits and losses are shared. Sometimes, they engage in sale and leaseback agreements. So while no interest is charged, the cost of borrowing is included in other ways.

b) Payday Lending

Payday Lending typically involves giving small, short-term unsecured loans, and these are thus sometimes also referred to as "Cash Advances". The cost for borrowing money on a payday loan is usually a fixed fee, rather than an interest rate. However, when this fixed fee is taken as an annual rate, the corresponding APR (annual percentage rate) can be very high compared to traditional forms of credit.

c) Fringe Lending

Fringe Lending is a term used to describe entities that offer loans that are considered outside of the mainstream financial system such as banks and credit unions. These lenders often charge high fees and interest rates, and offer loans to borrowers considered too risky by traditional lenders. The cost of these loans could be in the form of a flat fee, service charges, or very high interest rates.

d) Subprime Lending

Subprime Lending refers to the loan given to borrowers who are considered a credit risk, often due to a low credit score. These loans carry a higher interest rate than prime loans to accommodate for the increased risk the lender is taking. Although this is not a direct "charge", the higher interest rate can be seen as the added cost for borrowing money in this form of lending.

Key concepts

Islamic Lending

When discussing Islamic Lending, it's important to understand that it complies with the economic principles and moral values of Islam. Key to Islamic finance is the prohibition of 'riba', which means interest or usury. Lenders structure the financing in a way that avoids conventional interest-based transactions.

For instance, under the Mudarabah agreement, profits are split between investors and the borrower, resembling a partnership where both sides share in the gains and losses. Meanwhile, a Murabaha contract involves the lender purchasing goods and selling them to the borrower at a profit, where the payment can be made in installments. It's a transaction, not a loan, but still allows the borrower to delay full payment.

Another common approach in Islamic Lending is called Ijarah, where an asset is leased to the borrower while the lender retains ownership. The borrower benefits from using the asset and pays rental payments to the lender. These methods ensure ethical compliance and shared financial responsibility, making Islamic Lending distinct from its conventional counterparts.

Payday Lending

With Payday Lending, borrowers usually find a quick, albeit costly, solution for financial needs that arise before their next paycheck – hence the term 'payday loans'. They are typically small, short-term, and high-cost loans. They can seem convenient, but borrowers should be cautious.

Financial charges on payday loans can be steep, often a set fee based on the amount borrowed. If the loan isn’t repaid on time, additional charges can accumulate rapidly. When annualized, the fees can translate to an extremely high APR, far exceeding standard rates for personal loans or credit cards. This form of lending is controversial and considered predatory by criticism due to its exploitative fees and the risk it poses to borrowers who may become trapped in a cycle of debt.

Fringe Lending

Fringe Lending refers to alternative financial services offered outside of traditional banking. It includes a variety of non-bank lenders providing services to individuals often marginalized by the mainstream financial system. This group might offer payday loans, auto title loans, tax refund anticipation loans, and rent-to-own arrangements.

The defining characteristics of these services are the high fees and interest rates attached, reflecting the higher risk level associated with lending to borrowers with subprime credit histories. Accessibility comes with a downside, as the increased costs can lead to debt cycles for borrowers. Despite this, these lenders meet a demand for quick access to cash or consumer goods for those with limited credit availability.

Subprime Lending

Subprime Lending targets individuals who do not qualify for prime rates due to their less favorable credit histories. This type of lending encompasses various loan types such as mortgages, auto loans, and personal loans.

These loans come with higher interest rates than prime loans, compensating lenders for taking greater risks. While it increases accessibility to credit, it also raises the financial burden for borrowers due to the higher interest costs over time. While expanding financial opportunities, it's also been scrutinized for potentially leading to financial crises, as witnessed during the 2008 housing market collapse. Therefore, Subprime Lending is a double-edged sword — providing necessary credit to those it serves while carrying the potential for severe financial setbacks due to the accompanying higher interest rates.