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Understanding the principles of Islamic financing Understanding the principles of Islamic financing
Share this on WhatsAppIt is a widely known fact that Malaysia has one of the most advanced Islamic Finance industries in the world. Since... Understanding the principles of Islamic financing
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UdRpcdaHIt is a widely known fact that Malaysia has one of the most advanced Islamic Finance industries in the world. Since its initial introduction more than a decade ago, Islamic financing products have evolved and matured to be comparable and just as competitive as other conventional loan packages.

However, there are some key differences between Islamic loans and conventional ones, and understanding them will help guide you to make informed choices before you commit to any particular loan package.

Conventional financing principles

Under conventional financing schemes, lenders lend to borrowers to make a profit from the interest charged on the principal amount.

In the case of property loans, for example, borrowers pay interest on the outstanding principal amount. These interest rates can be a fixed or based on a floating rate.

Payment is usually made over a set tenure in the form of instalments. A portion of each instalment paid goes towards servicing the interest, while the remaining goes towards paying for the principal loan amount.

Since the contract is not based on an absolute value (such as the sale price), the sooner the borrower can pay down the principal, the cheaper the overall amount of interest paid will be.

The loan contract for conventional financing is commonly known as a Loan Facility Agreement.

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Islamic financing principles

Islamic financing is broadly based on Islamic principles and teachings, which means it avoids interest-based transactions (riba), which is considered unprincipled under Islamic law.

Instead, it introduces the concept of buying something on the borrower’s behalf, and selling it back to the borrower at profit.

In place of interest, a profit rate is defined in the contract. Similar to how conventional financing treats interest rates, profit rates can either be a fixed rate or based on a floating rate.

A large majority of Islamic home financing options available in Malaysia today are based on the Bai Bithamin Ajil (BBA) concept. There are, however, a small number of alternatives that are based on the Musyarakah Mutanaqisah concept which will not be discussed in this article.

The BBA concept

Under this concept, the principal amount, tenure and profit rate ultimately determines the “sale price” of the property and the profit earned by the lender. Like conventional financing, payments are deferred over instalments to be repaid over a set period of time.

As such, the loan contract for BBA Islamic Financing is known as a “Sale and Buy-Back” agreement.

The financing is broadly based on Islamic principles and it avoids “riba”, which means interest-based transactions.

The financing is broadly based on Islamic principles and it avoids “riba”, which means interest-based transactions.

Islamic v conventional financing

As part of the government’s efforts to promote Islamic Financing, in general there are a some advantages Malaysians can enjoy:

i) For an indefinite amount of time, there will be a 20 per cent stamp duty discount for Islamic Loan Agreement documents. However, it is important to note that there are only two legal documents necessary under conventional loan schemes – the Facility Agreement and Charge documents – while Islamic financing loans require at least three (sometimes four), which actually brings up the total legal costs.

ii) In cases of refinancing from conventional to Islamic packages, there will be a 100 per cent stamp duty waiver on the existing refinance loan balance. This is not applicable to any amount over and above the existing refinance loan balance.

Since its introduction, Islamic financing products have evolved to be as competitive as conventional loan packages.

Since its introduction, Islamic financing products have evolved to be as competitive as conventional loan packages.

Benefits of BBA Islamic Financing

Under the BBA concept floating profit rates are limited and are capped at a maximum. Conventional floating interest rates, however, have no such cap.

Also, under Islamic financing, late settlement of loans generally incur lower charges than conventional loans because there is no concept of compounding interest calculation. However, in practice, be warned that other fees and charges may apply that could offset this benefit.

Benefits of conventional financing over Islamic financing

Under conventional loan schemes, if a borrower alters the terms of the finance (e.g. increases the facility amount), the Loan Facility Agreement would only need to be up-stamped. Under Islamic financing, a new Sale And Buy-back Agreement (BBA) would have to be drawn up, making it the entire process a little more expensive.

Islamic financing schemes also have difficulty in restructuring or refinancing in the case of default. In conventional loan schemes, your costs for early settlements, late payments or defaults are more transparent in the contract as compared to Islamic financing.

Generally, Islamic financing is open to all, including non-Muslims, but there are certain issues attached to loans for commercial property or activities that go against Islamic teachings. For example, if your occupation is not deemed “halal”, there could be difficulty in obtaining a loan.

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Conclusion

With increasing maturity of Islamic finance, the differences between Islamic and conventional loan products have narrowed considerably.

If you are unsure whether a conventional or Islamic financing package is the best fit for you, take advantage of the many loan comparison tools available online now (such as the Loanstreet Home Loan Comparison tool) and select both Islamic and conventional options to make a direct comparison for your particular loan requirements.

This way, you can compare the best packages both options have to offer.

 

This article is courtesy of Loanstreet.com.my, an independent loan comparison and application website that also offers personal financing tips. Visit the website to learn more about your current financing options.

Property 360 Online

Property 360 Online is a news portal focused on major issues, views and major market movements in the Malaysian real estate sector.

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