Is Islamic Financing created just to entice Muslims even though it’s similar to Conventional Financing? Do they receive an advantageous benefit from Islamic financing? The answer to both those questions is “No”. In actual fact, Islamic financing has key differences that make it different from Conventional financing. It is also open to all individuals regardless of their religious behaviour.
Then the following question would be why is there Islamic Finance then? What are the differences between Islamic and Conventional Finance? Should everyone take up Islamic financing?
What’s the difference between Islamic and Conventional banking?
Islamic finance is based on Shariah law which translates to it being an ethical banking system with considerable differences from conventional banking. Today, we’ll cover these 5 main differences of Islamic financing compared to Conventional financing.
1. Interest is prohibited in Islamic Financing.
The risks are not fairly shared when there is an obligation to pay for interest (riba). Hence, Islamic financing operates on the principle of profit and loss sharing instead. Contracts like Mudarabah operate under the Shariah law and the profits and losses are shared between the financier and entrepreneur. Whereas, in Conventional Financing, the financier is contracted to receive interest regardless of the condition of the borrowers’ business. In the future, we will cover more on common Islamic contracts.
Islamic financing is also an Asset Based financing where trade or gambling elements are prohibited. For example, industries that harm society like alcohol and tobacco are not permitted to receive financing from Islamic Banks. Under the Shariah law, the Conventional Banking system is considered unethical and profit-oriented in making money through interest.
2. Islamic Home Financing has a predetermined ceiling rate.
In Islamic home financing, there is a ceiling profit rate which is based on the Islamic Base Financing Rate. It cannot exceed the predetermined ceiling rate but it can be adjusted based on market conditions. This ensures protection for the customer against high fluctuations in the benchmark rates. For Conventional Banking, there is no ceiling rate and is adjusted based on market conditions. This might mean that you’ll end up paying a higher instalment amount if there is a major interest rate hike.
3. Islamic banking customers pay late payment penalties to charity
Unlike Conventional Financing where penalty charges from customers are taken as income by the Bank, in Islamic Financing, the customer instead takes the amount and uses it to pay for charity. A late payment fee is prohibited as it is considered a form of interest. So, to avoid misuse of this, an alternative to pay that amount to charity came about.
4. “Loans” are not permitted in Islamic Financing
For Islamic Financing, “loans” they must be interest-free as they are recognised as non-commercial and to be excluded from commercial transactions. Compensation is always price (Thaman) in Islamic Financing as opposed to interest for Conventional financing. For example, the Islamic bank will purchase the commodity and profits are earned through the exchange of goods and services. While in Conventional banking, the financier loans the money and charges interest on capital based on a time-value instead.
5. Islamic financing has no lock-in period
Lower charges for late settlement of loans compared to Conventional loans since there are no compounding interest calculations. Though there could potentially be other charges to offset this benefit. To impose a penalty when a customer is attempting to pay of their debt goes against Islamic financing. Islamic banks normally absorb the legal fees which can be recovered if early settlement is made. This has made Islamic financing popular for customers who seek short-term financing.
In the Conventional Banking world, the process for onboarding a customer can take many months involving a lot of parties. Thus, banks naturally want to impose a minimum “lock-in” period between 3-5 years to safeguard and earn as much income as possible from the customers. If customers sell, settle or refinance their home financing in this case, they are imposed an early settlement penalty.
In Malaysia, Islamic financing is high and still increasing with a sustainable growing acceptance of Islamic financial products and services among the population. Speculative risk-taking is prohibited under Shariah, hence, Islamic banks minimize risk by default and investigate and monitor the businesses thoroughly. However, there are challenges in Islamic banks’ risk management. Some instruments that conventional banks use are not available in Islamic banks which include financial derivatives. The main benefits that I can take away from this are that the basis of Islamic financing is ethical and is less risky with profit and loss sharing which is based on real activity.