What Exactly Is Shariah Compliant Personal Financing?

These aren’t exactly loans in the modern sense; having a substantial philosophical difference between the two.

Loans form a crucial part of the modern financial system. Banks lend out money with the intention of making a profit; mostly by charging interest. However, this conventional model doesn’t quite fit with Islamic principles.

Here’s where Islamic banking plays a vital role today.

Shariah compliance is becoming increasingly important as banks look to tap the world’s growing number of Muslims. In Malaysia, Muslims account for 61% of the population; making for a potentially huge market.

In this case, it is in the interest of banks to not only offer Shariah compliant financing, but also show how the system can benefit their customers. Essentially, it offers a way for financial institutions to offer interest-free loans and still turn a profit.

Shariah compliant financing

Islamic finance doesn’t allow for the concept of interest, or riba. This generally prevents the traditional method of making money through lending it out. This is because Shariah rules do not allow for money to have intrinsic value, treating it only as a medium of exchange.

Due to this difference in philosophy, Malaysian banks use a different system based on the concept of Bai’ Al-‘Inah. Here, banks will use a commodity as a medium of exchange to facilitate the transfer of funds.

It is this difference that requires Shariah compliant loans to be offered in the form of ‘personal financing’ instead.

How does it work?

There are two ways that a Shariah compliant personal loan can happen: Murabahah or Tawarruq. Both concepts are similar, but require different steps to achieve the same thing.

In a Murabahah, the bank purchases whatever the customer wants and sells it to them with a markup. In this case, the repayment is done in installments and the profit that would have come from charging interest is instead replaced with the profit from the sale of the asset.

A notable difference with conventional personal loans is that the customer will be informed of the total amount that needs to be repaid from the very start.

A Tawarruq contract builds on a Murabahah, only with more steps to reach the desired goal.

In this type of financing, the customer buys commodities from the bank (paying for the value plus the bank’s profit rate). At this stage, the payment is deferred because the customer clearly doesn’t have the funds yet.

Next, the customer sells the commodities to a third party to obtain cash. From here, the customer is expected to pay the bank back for the initial purchase on an installment basis.

For example: You apply for RM200,000 in personal financing from Bank Islam. You want to take your maximum amount of time to pay this back, so you ask for a 10 year tenure period.

In this case, the bank would help you buy RM200,000 worth of commodities. In this case, let’s say it’s beef (almost any physical object can be a commodity). You now owe the bank RM200,000 plus a profit of say 8%. So overall the value of the transaction is now RM216,000.

At this point, you owe the bank money and own a warehouse full of beef. To get the actual funds, you would then sell the beef to a third party for exactly RM216,000. Giving you the financing that you wanted in the first place.

This entire process is performed by the bank, so the customer doesn’t even need to be aware that all of this is happening.

It should be noted that gold, silver, and currencies cannot be used as commodities for the purpose of a Tawarruq transaction.

Not only for Muslims

Despite being based on Shariah principles, Islamic personal financing caters to everyone. On the whole, the profit rates are generally lower than interest charged by conventional loans.

Shariah financing places a bigger emphasis on helping people to use financing to obtain what they want rather than making profit the primary goal.

For instance, Bank Islam occasionally offers special rates for specific professions that may need it. From 13 November 2018 to 13 January 2019, the Bank Islam Personal Financing-i reduced the floating profit rate for teachers and nurses by about 50%.

More importantly, the concept of Murabahah means that the total value of the agreement is known from the very beginning. So you always know what you’re getting into without having to calculate compound interest on your own.

It is literally more transparent than a conventional personal loan about how much you end up owing the bank.

After all, what you really want is being able to make an informed decision on money matters, especially if it’s going to involve a long term financial commitment to a bank.