Islamic finance is a financial system which operates in accordance with shariah or Islamic law. The primary difference between Islamic and conventional finance is the treatment of risk. Under Shariah law, finance is based on the principle of “profit and loss sharing,” meaning a lender shares equal financial risk. Therefore, the underlying ethical code of Islam requires banks to minimize the risk of default. Since its initial conception, Islamic financing has evolved to be competitive as many other conventional loan packages. Some of the main components of Islamic finance are outlined below.
No Interest Payments
Islamic financing prohibits interest-based transactions or “riba,” which ultimately protects a purchaser from having to pay compounded interest. Because Islamic finance does not allow the payment of interest, the system introduces one of many concepts of making a purchase on a borrower’s behalf and selling it to the borrower at a profit – also known as Murabaha. Other concepts include partnership (Musharaka) and leasing (Ijara).
A prime example of the difference between the two forms of finance would be mortgaging. Financial services, such as those run by Manzil, are able to provide what is known as a Halal mortgage. A Murabaha mortgage involves a larger down payment compared to the conventional counterpart, but does not charge interest over time. Manzil and it’s team of professionals work with clients to determine a set price and repayment terms, taking into consideration an individual’s risk profile, property value, and repayment length. Manzil then purchases the property and sells it back to the client including an agreed-upon profit. Home buyers pay month to month as they would with any other mortgage until it is fully paid off. The sale is recorded in a Murabaha mortgage contract.
The ethics behind Shariah law do not eliminate all potential risks involved in a financial transaction, but instead seek to mitigate it, whereas conventional finance typically places the risk on the borrowing party. Ultimately, because all profits are shared between parties; in this case the lender retains the profit on the resale and the borrower retains the profit on the asset (house), both parties share equal risk. Similarly, purchasers can repay a loan at any point in time without being subject to penalty.
Why Choose Islamic Financing?
Islamic firms distinguish themselves by avoiding interest and speculative risk. Similarly, financing is an affordable alternative for individuals wanting to own a home without compromising their beliefs. Despite the complexity of the financial sector, by performing extensive research, individuals will soon learn that the Halal financial system poses various advantages over conventional methods.
Mohamad M. Sawwaf is the Chief Executive and Co-Founder of Manzil.