What Is the Relationship Between IRR and Interest Rates?

Author Credit:

This blog is adapted from an article by Muhammad Rizwan-ul Haque, Founding Chairman of Dawood Family Takaful, CEO of an Investment Bank, and Director of a Trust. The original article was published on August 7, 2015.

Introduction

Internal Rate of Return, commonly known as IRR, is an important financial concept used to evaluate the profitability of a project or investment.

In simple terms, IRR helps investors understand whether a project is worth pursuing. It is commonly used in budgeting, investment analysis, and financial modelling to estimate the expected return from a project.

However, when IRR is compared with interest rates, especially in economies where interest-based instruments dominate, an important Islamic finance question arises: does this relationship affect real economic activity?

What Is IRR?

IRR is the rate of return at which the net present value of a project becomes equal to zero. In other words, it is the discount rate at which the present value of a project’s expected benefits equals the present value of its costs.

If a project has a higher IRR, it is generally considered more attractive. If the IRR is too low, investors may reject the project.

This is why IRR is widely used by financial experts, economists, entrepreneurs, and investors when deciding whether a project is financially viable.

The Role of Net Present Value

To understand IRR, it is also important to understand Net Present Value, or NPV.

NPV calculates the present value of future cash flows. Since money received in the future is considered less valuable than money available today, future cash flows are discounted back to their present value.

IRR is the rate at which the project’s future cash flows balance out the cost of investment. This makes it a useful tool for comparing different investment opportunities.

Why Is It Called “Internal”?

The word “internal” means that the calculation is based on the project’s own expected cash flows. It does not directly include external factors such as inflation, market interest rates, or government bond yields.

However, in real-world financial decision-making, investors often compare IRR with external benchmarks, especially interest rates and returns on fixed-income securities.

This is where the concern begins.

How IRR Is Compared With Interest Rates

In modern financial modelling, investors often compare the expected IRR of a project with prevailing interest rates or returns offered by government bonds and fixed-income securities.

For example, if a debt instrument offers a guaranteed return, an entrepreneur may only invest in a business project if the expected return is higher than that guaranteed return.

This comparison can discourage real investment. If interest-based instruments offer easy and relatively secure returns, investors may prefer them over productive business activity.

The Islamic Finance Concern

According to Muhammad Rizwan-ul Haque, this is one of the major harms of Riba. When interest rates exist as a guaranteed benchmark in the market, investors begin comparing every project against them.

As a result, many projects that could create jobs, goods, services, and economic benefit may be ignored simply because their expected return is lower than the available interest-based return.

From an Islamic perspective, this creates a serious imbalance. Instead of encouraging real economic activity, interest-based systems may encourage capital to remain in debt instruments.

Why Riba Was Forbidden

The article highlights that Allah SWT has declared Riba forbidden with great wisdom. If there is no guaranteed interest-based return available in the market, entrepreneurs and capitalists may be more willing to invest in real projects, even when the expected return is modest.

This can increase economic activity, create employment, produce goods and services, and help maintain balance in society.

In this way, the prohibition of Riba is not only a religious command. It also protects society from an economic system where money makes money without contributing to real production.

Riba and Economic Imbalance

Interest-based returns can create a mindset where investors constantly seek guaranteed increases in wealth.

This may reduce the willingness to take business risk, support entrepreneurs, or invest in productive sectors of the economy.

When money flows toward fixed-income instruments instead of real economic activity, society may suffer from fewer jobs, less production, and greater inequality.

This is why Riba is not just a technical issue. It affects the structure and direction of the entire economy.

The Alternative: Zakat and Charity

The article also reminds readers that the Qur’an emphasizes Zakat, charity, and spending in the path of Allah SWT before sternly warning against Riba.

This creates a powerful contrast. Riba is based on increasing wealth through guaranteed gain, while Zakat, Sadaqah, and Khairat are based on giving wealth for the benefit of others.

In worldly terms, giving may appear to reduce wealth. But in Islamic belief, spending in the path of Allah SWT brings true reward and long-term benefit.

A Message to Reflect Upon

Modern economies often measure success through financial increase, return, and accumulation. But Islam teaches that true success is not only in gaining more wealth.

Sometimes, real benefit comes through spending, helping, sharing, and avoiding prohibited income.

This is a deep message. In worldly life, people often chase Riba because it promises increase. But Allah SWT shows a different path, where real gain comes through obedience, generosity, and justice.

Conclusion

IRR is a useful financial tool for evaluating projects. However, when it is constantly compared with interest rates, it can discourage real economic activity and push investors toward guaranteed interest-based returns.

The Islamic prohibition of Riba protects society from this imbalance. It encourages capital to move into trade, production, services, employment, and real economic development.

For Islamic finance to remain true to its purpose, it must avoid using interest rates as the foundation of financial decision-making and focus instead on ethical, productive, and Shariah-compliant investment.

Credit: 

This blog is adapted from the article by Muhammad Rizwan-ul Haque, Founding Chairman of Dawood Family Takaful, CEO of an Investment Bank, and Director of a Trust.