There is a very straightforward method to determine if a particular investment’s payout is Halal or Haram. Simply ask:

Are the investors’ returns a function of how much they invested or are they a function of how much profit the investment generates?

If the investors’ returns are a function of how much they invested, this is Haram (prohibited in Islam).

On the other hand, if the investors’ returns are a function of how much profit the investment generates, this is Halal (permissible in Islam).

Consider the following two investments:

Investment AInvestment B
Offers 10% annual return on investment. Offers 10% of investment profits
Investment A payout = 10% X Investment Amount Investor B payout = 10% X Investment Profits (if they exist)
Investment A payout is a function of Investment AmountInvestment B payout is a function of Investment Profits

Investment A’s payout arrangement is prohibited in Islam whereas Investment B’s payout is permissible.

Why is this? Why is it that Islam prohibits investments where the payout is independent of the outcome and allows investments where the payout is outcome-based?

The reason is that when investor payout is independent of the outcome, the investor is not incentivized to care about the outcome.

Consequently, things that make no sense to finance end up getting financed if the financier thinks the financed will be able to make their payments, however painful this may be for the financed, or the financier expects the financed will default and has their eye on the collateral they will gain ownership of.

Recall the 2008 financial crisis. Banks started lending unqualified borrowers to buy homes, in hopes of foreclosing on the purchased homes and selling them at a profit.

The flip side to this equation is when the purchased home becomes worth less than the amount borrowed to purchase the home. In which case the borrower has incentive to walk away from their obligations and leave their lender with a loss.

As of June 30, 2018, nearly one in 10 American homes with mortgages were “seriously” underwater, according to Irvine, California-based ATTOM Data Solutions, meaning that their market values were at least 25 percent lower than the balance remaining on their mortgages.

Islam strives to eliminate this toxic dynamic. If you want to earn permissible profits, your payout must be determined by the outcomes of your investment. This serves to align the interests of the financier and the financed. (If you would like to know how Islamic finance works, see the financing product we’ve pioneered at BFF Income Share Funding.)

In an Islamic investment, the percentage of profits owed is fixed while the payout is variable.

In a non-Islamic investment, the percentage of profits owed is variable while the payout is fixed.

Accordingly, there is no such thing as an Islamic fixed income product.

Fixed income means the future payouts are predetermined. Since the future performance of anything cannot be guaranteed, fixed future payouts mean the payouts are independent of the performance of the underlying asset. As we pointed out, this is Haram (prohibited in Islam).

To check your investment portfolio for Islamic compliance, start with making sure you have no investments in fixed income products, the most common type of which are bonds.

So the next time you are considering an investment, ask yourself: Is my payout predetermined or is it a function of how well the investment performs?

If payout is performance based, it is Halal (permissible in Islam).

If payout is predetermined based on amount invested, it is Haram (prohibited in Islam).