Do You Really Know the Difference Between Islamic & Conventional Banking?

Banking LQ

For many people, the concept of Islamic banking is something that they know exists, but don’t quite know what it is. In this article we’ll first explain what conventional and Islamic financing are and how they’re different from one another. We’ll also talk about the benefits of both, particularly in the context of home financing. From there you can decide — which one suits you best?

Conventional Financing

Most of us are quite familiar with conventional banks and know that their profit comes from charging an interest on the outstanding principal amount of a loan. These interest rates can either be fixed or they can be a ‘floating rate’, which usually depends on a bank’s BLR (base lending rate).

The total amount of interest paid by the end of the loan tenure can vary greatly and is reliant on several factors:

– The interest rate and its potential increase/decrease over the years
– How quickly the borrower repays the principal amount
– Whether or not the borrower is late with his/her payments or defaults on the loan (bank may issue extra charges and/or higher interest rates)

Islamic Financing

Truth be told, there aren’t too many dissimilarities between conventional and Islamic financing. The one big difference is that Islamic banks do not implement the concept of interest as it is seen as exploitative. Instead of loans, then, Islamic banks operate under the principle of buying and selling — they will ‘buy’ something on your behalf and sell it back to you at a marginal profit (the rate of which is defined in the contract. It can either be fixed or dependent on a Base Financing Rate).

So where your relationship with a conventional bank would be as borrower/lender; your relationship with an Islamic bank would be as buyer/seller, or even a joint partnership.

 

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Types of Islamic Financing

Islamic financing splits into two different concepts: Bai Bithamin Ajil (BBA) and Musyarakah Mutanaqisah (MM).

BBA falls under the Murabahah concept and is the most popular option for home buyers looking for a housing loan (though of course as we’ve discussed, the word ‘loan’ when applied to Islamic financing is not quite accurate).

Under this concept of financing, the bank will buy your desired property and sell it to you at a profit. Like conventional housing loans, you pay in monthly instalments over a specified tenure. This is known as a Sale and Buy-Back Agreement.

MM means that a partnership is formed between the bank and the customer in order to buy the desired property. Then, instead of selling it to you, the bank leases it to you at an agreed rental price (principal repayment with profit) while gradually decreasing its shareholder status over the years.

Why Choose Conventional Over Islamic?

Transparency

Extra charges for late payments, defaults, etc. are stated more clearly in the contracts of conventional banks compared to Islamic banks.

More organisation

In the event of a default, conventional banks are better at restructuring and/or refinancing.

No ‘halal’ requirement

It’s a popular misconception that a person has to be Muslim to apply for Islamic financing. Not true. However, your occupation and reason(s) for financing must be deemed halal or else it will be difficult for the bank to give you the loan. Conventional banks have no such requirement.

Less paperwork

In the case that a borrower wishes to change the terms of the loan, the Loan Facility Agreement only needs to be up-stamped. Under Islamic financing (i.e. BBA), a brand new Sale and Buy-Back Agreement needs to be drawn up, therefore incurring more legal costs.

Additionally, conventional loans require only two documents; Islamic financing commonly requires three to four.

Why Choose Islamic Over Conventional?

No interest

Because Islamic banks charge in terms of a profit that is set from the very beginning, customers do not need to worry about increasing interest rates. Even for floating profit rates, there is a maximum limit that it cannot exceed; floating interest rates have no limits.

Government discounts

The Malaysian government aims to promote Islamic financing throughout the nation and is therefore offering certain discounts. There is a 20% discount on stamp duty for Islamic loan agreement documents and a full stamp duty waiver for those refinancing from conventional to Islamic financing.

Shared risk

Borrowers of conventional banks bear the full risk of paying back the loan. Islamic banks bear a portion of the risk because of its ‘loan’ principles, especially under the MM concept.

Available to Muslims and non-Muslims

Provides more options to people who don’t find conventional financing appealing.

 

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You should now have a clearer idea of what Islamic financing is all about, and how it compares to the conventional. The differences are minimal, especially now as Islamic financing continues to evolve and improve. Many people’s preference for conventional banking merely boils down to perception. In the end, it’s down to you to decide which one attracts you most.

It’s a big decision to make so we suggest you thoroughly research all your options. And when you have decided, NuProp should be your next stop to shop for your new home!

 

 

Images: Freepik.com (geometric designs)