What is Islamic finance?
More than £3 million Brits are Muslim and there is an increasing market for Islamic financial products. If you’re a Muslim business owner, you may be looking for Islamic finance for your business. Islamic finance, based on Shariah law, is a different system to traditional bank finance. Instead of paying or charging interest, Islamic finance uses a type of profit sharing between the bank and the borrower. In this guide, we take a look at the question , “what is Islamic finance?” and answer common queries like “how does Islamic finance work” and “is Islamic finance more expensive?”
Table of Contents
- What is Islamic finance?
- How do I apply for Islamic finance?
- Where to find Islamic finance
- Frequently asked questions?
What is Islamic finance?
Islamic finance is based on Shariah, or Islamic law. It is based on the belief that money doesn’t have any value in itself and it shouldn’t be used to make more money in the form of interest. Instead of charging interest, Islamic finance encourages financial partnership between banks, business partners and individuals.
There are 4 main rules for Shariah compliant finance as follows:
- No interest is charged on loans as this is viewed as Riba or usury.
- Lenders must not be involved in forbidden activities like gambling, alcohol and other speculation.
- Lenders must not invest in high risk investments.
- Traditional insurance isn’t allowed because insurers make a profit from a risky activity.
Summary of Islamic finance terms
Here is a summary of some of the main financial terms used in Islamic finance:
- Riba or usury: banks charging interest in exchange for lending. This isn’t allowed under Shariah law.
- Qard: a type of bank account that doesn’t pay interest. Instead, you invest your deposit interest free, the bank invests the loan and gives you a share of their profits.
- Wakalah: your bank acts as your agent
- Murabahah: your bank buys and trades commodities or property to earn a profit
- Musharakah: a type of mortgage partnership contract where you gradually pay the bank for its share of the property.
- Gharar: contracts with excessive risk or uncertainty like traditional insurance contracts. These are forbidden under Shariah law.
- Haram: this described financial activities that are forbidden under Shariah law
- Ijarah: a type of finance leasing where a business or individual can use the object for an agreed period. Some leases allow the business to buy the asset at the end of the lease for a predetermined sum.
- Maisir: Restrictions on gambling and speculation
- Takaful: Islamic insurance where premiums are pooled
- Halal: a term to describe Shariah-compliant finance
How does Islamic finance work?
Islamic finance works by providing financial services that are Halal or compliant with Shariah law. Here is a summary of how the main types of Islamic business finance work:
- Bank accounts: Islamic finance current accounts don’t pay interest or charge like a traditional bank account. There is no planned overdraft, no minimum balance requirement and no charges for transactions. Instead of paying interest, Islamic bank accounts work by investing your money and offering you an expected profit rate. This profit rate isn’t guaranteed and may sometimes fall short. Any profit you earn is taxed in the same way as interest.
- Loans: like current accounts, lenders invest your money and offer a share of the profits.
- Mortgages: you won’t be charged interest, but instead will pay fees and charges.
- Insurance: Islamic insurance works by pooling premiums, and withdrawing money from the pool when you make a claim.
Where do Islamic banks invest?
Islamic banks invest in mutual funds that are screened to make sure they’re compliant with Shariah law. They have a filter to check whether businesses trade in any prohibited activities or hold too much debt.
Shariah law has strict rules about suitable investments. Here is a summary:
- No interest: bank accounts can’t pay interest. Instead, banks invest your deposit and share their profits on the investment.
- Only permitted investments: banks can’t invest in anything the Shariah defines as harmful, like gambling or alcohol.
- There are specific Islamic indices where individual investors can invest, including the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.
How do Islamic business loans work?
Islamic business loans don’t charge interest. Instead, finance providers charge monthly fees for lending. You may also be charged additional fines if you default on your payment.
Asset based finance is a type of an Islamic finance where the finance provider buys an asset directly and sells it to your business for a profit. It’s both Halal and Sharia law finance compliant as it adheres to the central teachings of Islamic Law. If the client defaults on repayment, the financing facility isn’t allowed to charge any additional late fees.
How does Islamic mortgage finance work?
Islamic mortgage finance works slightly differently to a traditional mortgage as no interest will be charged. Instead, the bank charges you extra fees to cover their costs and to charge you for living in their property.
A Murabahah is a type of mortgage contract where your bank buys the property and sells it to you at a profit, whereas a Musharakah is a partnership contract where you gradually pay the bank for its share of the property.
What are the rules on Islamic insurance?
Traditional insurance is not permitted under Islamic law because you’re purchasing something where the outcome is very uncertain and is based on risk. Insurance companies can make a profit if claims are lower than the expected level.
Instead, an allowable alternative is mutual insurance. This is where subscribers contribute to a pool of funds, which are invested according to Sharia rules. Funds are then withdrawn from the pool when claims are made and unclaimed profits are distributed to policyholders. This type of insurance is sometimes known as Takaful.
How do I apply for Islamic finance?
You can apply for Islamic finance in a similar way to traditional business finance. You will usually need to provide the following information:
Details about your business and the business owners Information on how much you want to borrow and for how long Details of what your loan will be used for
Where to find Islamic finance
There are many Islamic compliant banks in the UK and some traditional banks also offer options for those wanting Islamic finance. Here are some options to consider:
Frequently asked questions
Is Islamic finance halal?
Islamic finance is halal if it complies with Sharai law. This means it fits with Islamic laws on lending like charging no interest and only investing your money in allowable business sectors.
Do you have to be a Muslim to apply for Islamic finance?
No, you don’t have to be a Muslim to apply for Islamic finance. However you can’t apply if you run a business that trades in prohibited activities including gambling, drugs, weapons, chemical manufacture, pornography, banking and money transfer services.
Even if you’re not a Muslim, it’s worth considering Islamic finance products for your current account. Islamic products sometimes offer a better deal than traditional banks, especially in these times of low interest rates..
Is Islamic finance more expensive?
Islamic finance can be more expensive due to additional administrative costs. It’s also possible that you’ll require a bigger deposit for a loan. For example, Shariah-compliant mortgages usually require a deposit of at least 20%.
You should check the terms and conditions of your agreement when you apply for finance to see what fees you’ll be charged.
How do I know a lender is compliant with Shariah law?
Lenders should be able to prove that they’ve received Sharia compliance guidance from an authority in Islamic law.
Islamic banks, such as the Al Rayan Bank, have a Sharia Supervisory Committee to make sure investments are compliant with Sharia law.
Is Islamic finance regulated?
Yes, islamic finance is regulated by the Financial Conduct Authority (FCA), on the same basis as traditional finance. You should bear in mind that certain types of business finance, like invoice financing, are currently a non-regulated activity.
Where can individual Islamic investors invest?
If you’re and individual Islamic investor and you want to invest in a a Sharia compliant way then you have the following options:
- Stock and shares - you can invest in specific Islamic indices such as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.
- Property - you can buy an investment property using an Islamic mortgage