A typical conventional bank earns money from interest by lending out money to consumers. You will enter into a loan agreement and the agreement will stated, amongst others, the amount you borrow, interest rate, the instalment amount and the loan tenor.
But that concept does not apply to Islamic banks. In Islamic banking, every banking activity must not involve interest. This is because in Islamic teachings, it refrains their followers from giving or receiving interest.
To have a better understanding of what is halal financing, let us share with you on what is Islamic financing and the differences between Islamic Financing and Conventional Loan.
- What is Islamic Banking?
- Islamic Shariah Financing Principles
- Differences between Islamic Financing & Conventional Loan
- Benefits of Islamic Personal Financing
- Considerations for Islamic Personal Financing
- Which Shariah terms to take note in Islamic Personal Financing?
- Need a trusted Islamic Personal Financing?
What is Islamic Banking?
Islamic banking is a financial system that complies with the Islamic Law (Shariah). The main reason for the establishment of Islamic banks is to provide and fulfill the Muslims’ banking needs based on the teachings of the Al-Quran and Al-Sunnah. The Islamic banking principles focus on the concept of mutual risk and profit sharing, the practice of fairness and transactions are performed based on an underlying business activity or asset.
Islamic Shariah Financing Principles
All of the Islamic banks in Malaysia practices Shariah-compliance whereby all financing activities must not contribute the following:
- Riba (Paying or charging interest)
- Haram (Investing in business conducting prohibited activities i.e. alcohol, gambling)
- Gharar (Uncertainty and excessive risk)
- Maysir (Speculation or gambling)
Generally, Islamic personal financing falls into one of the 2 concepts below – Bai’ Al-Inah and Tawarruq. Here we explain these 2 concepts in more detail.
Bai’ Al-‘Inah (Bai-Inah)
To breakdown the terms of Bai-Inah, Bai = sale, tijarat = trade and ribbh = profits on a sale. In simpler terms, Bank Negara Malaysia (BNM) defines Bai-Inah as “a sale contract followed by repurchase by the seller (the financier) at a lower price”.
Here’s an illustration to describe how does the Bai-Inah contract works. Basically, there are two contracts in the Bai-Inah concept. The first contract is known as Asset (or Commodity) Sales Agreement. The second contract is known as Asset (or Commodity) Purchase Agreement. To start, let’s assume that a customer applies for a personal financing of RM10,000 from an Islamic Bank (the Financier).
- In the first contract, Financier sells its asset to the Customer with the price of RM12,000 on deferred payment.
- Customer will pay a monthly installment of RM500 for 24 months to Financier as per the agreed contract.
- In the second contract, Customer then sells the asset back to Financier in order to obtain cash.
- Financier pays RM10,000 to Customer on a cash basis.
To summarise, the financing amount that the Customer would receive is RM10,000. The additional RM2,000 from the RM12,000 deferred payment is the profit earned by the Financier. The contract will be considered ‘fulfilled’ when the customer receives the cash and sells back the asset/commodity to the Financier. This means that in order for the Bai-Inah concept to work, the first contract (Asset/Commodity Sales Agreement) has to happen before the second contract (Asset/ Commodity Purchase Agreement).
Generally, the concept of ‘Tawarruq’ is similar to ‘Bai-Inah’; except that the difference is ‘Tawarruq’ involves an existence of a third party in between, usually known as an agent or broker. ‘Tawarruq’ is described as a buyer who buys an asset or commodity on a deferred basis. Then the buyer sells the asset on a cash basis to a third party. Here’s an illustration to describe how does the ‘Tawarruq’ contract works in a simplified manner.
Customer wants to apply for a personal financing of RM10,000. Similar to Bai-Inah, there are 2 contracts involved:
- In the first contract, Financier sells the commodity of RM12,000 to Customer. Customer will pay the purchase of commodity on a deferred basis through installment of RM500 for 24 months
- In the second contract, the Customer then sells the commodity at RM10,000 through a sales agent appointed by Financier
- Agent buys the commodity RM10,000 in cash and Customer obtains the cash as the financing
In summary, the total financing amount that the Customer would receive is RM10,000. Similarly, to the ‘Bai Inah’ concept, the additional RM2,000 from the RM12,000 deferred payment is the profit earned by the Financier. The ‘Tawarruq’ contract is considered complete when the customer purchases a commodity from the Financier and then the customer sells that commodity to a third party (agent) to obtain RM10,000 in cash.
In more detail, the first contract under Tawarruq’ is called “Murabahah”, where the cost-plus-profit has been made known to the Customer, i.e. the Customer is aware of the profit made by the Financier.
Generally, it is important to know which Islamic concept is being applied by the financial institution to ensure that the financing you are getting is Shariah compliant. As you can see now, when you enter into Islamic personal financing, you will encounter an asset/commodity sales agreement rather than a loan agreement. But don’t worry, you will not be physically receiving or selling the commodity involved as you can see from the flow chart, the buying and selling are happening at the same time and the process will be handled by the financiers.
Differences between Islamic Financing & Conventional Loan
This is a simplified table to help you better understand the key differences between Islamic Financing and Conventional Loan. While both products will allow you as a consumer to receive the financing you require, but the documentation and terminology used are different:
|Islamic Financing||Conventional Loan|
|Facility||Personal Financing||Personal Loan|
|Contract||Asset or Commodity Sales Agreement either using Tawarruq or – Bai’ Al-‘Inah concept||Loan agreement between borrower and lender|
|Financing/ loan amount||The asset or commodity sales agreement will state both the|
– asset sales price (this is basically the amount customer has to pay back for the whole agreement)
– the asset purchase price (this is the financing amount the customer receive on day 1)
|Loan contract will state the loan amount|
|How the lender makes money?||Profit rate: Profit that earned from buying something on behalf of the customer (borrower)||Interest rate: Interest charged on the principal amount and paid by the borrower|
|Business scope||Financing of illegal/Non-Shariah compliant activities are prohibited i.e. gambling, drugs, alcohol, etc.||Provide loan to individual/business that does not engage in illegal activities but could be Non-Shariah compliant activities|
|Late payment||Compensation (ta’widh) will be charged on the unpaid amount||Penalty of compounding interest will be imposed on the outstanding loan|
|Early settlement||Generally rebate (ibra) is provided by financier on the sale price for early settlement||Allowed. May have a penalty for early settlement if the loan has lock-in period|
Benefits of Islamic Personal Financing
1. Promote financing that aligns with Shariah
The main principle practiced in the Islamic model is financial justice. With the concept of risk-sharing and the sharing of profit or loss between the bank and lender, it creates a more balanced distribution of income and wealth; instead of making the borrower to be liable for all the risk involved.
2. Non-compounding on late payment fees
There is no compounding late payment interest charged. Borrowers only need to pay for the late payment fees that are charged on the outstanding balance. This means that Islamic financing has a lower late payment fees.
3. Flexibility in early settlement
Islamic personal financing allows you to perform an early settlement at anytime and a ‘ibra’ (rebate) will be given. For conventional personal loan, there might be a lock-in period. Thus, for conventional loan, any early settlement performed before the lock-in period will incur a penalty.
4. Open to everyone
Islamic banking is not restricted to Muslims only even though it is based on Shariah principles. Non-Muslims are welcome to apply Islamic Personal Financing to enjoy its benefits.
Considerations for Islamic Personal Financing
1. More documentations for Shariah-compliant financing compared to conventional loan
To comply with Islamic financing requirement, there will be both asset/commodity sales agreement and asset/commodity purchase agreement. In addition, there might be ‘agent’ involved to assist in the sales & purchase of commodity for personal financing following ‘Tawarruq’ concept. But once you understand the concept, then it will be straightforward.
2. A new documentation will be required in the event of a restructuring of the financing
Compared to a conventional loan, if the financing required restructuring or changing key terms, it will likely require entering a new contract. This may result in a higher cost.
Which Shariah terms to take note in Islamic Personal Financing?
Before you decide to apply for a personal financing, let us share with you on some Shariah terms that you may generally come across in the application form or in the contract itself.
|Bai’ Al-Inah||A sale contract involving the sale of assets to the buyer on a deferred payment and the subsequent purchase of the asset sold at cash price lower than the deferred sale price.|
|Tawarruq||A contract involving a buyer who buys an asset or commodity on a deferred basis. Then the buyer sells the asset on a cash basis to a third party to obtain cash.|
|Wa’d||A promise of one party which refers to an expression of commitment given by one party to another to perform certain actions in the future.|
|An agreement between two parties. The financier offers the customer to enter into a personal financing transaction and the customer agrees to accept the offer.|
|Takaful||Insurance coverage provided by the financier which covers death and total permanent disability (TPD).|
|Ibra||Known as rebate. Depending on the financier’s discretion, a ‘Ibra’ would be given to the borrower if the facility has been fully settled before its maturity.|
|Wakalah Fee||Known as agency or service fee to be paid to the agent or ‘wakil’ (representative) to manage the authorised task or matters.|
|Ta’widh||A penalty charged to the borrower for the delay in payment.|
Need a trusted Islamic Personal Financing?
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