How does ‘Sharia Finance’ Differ From Regular Lending

20Dec10

Sharia banks operate very differently than regular banks, especially when it comes to loans and interest.

Sharia finance refers to banking activity which is consistent with Islamic Law. There are many ways that Sharia financial practices are different from regular lending, such as the way Islamic banking regulates loans. Just as first time buyer mortgages are aimed at a particular demographic, Islamic finance is aimed at a particular niche, however it is one that is attracting attention from outside of that.

In many ways, Islamic banking operates on the same principles as conventional banking: the banks make money by lending out their capital. One of the major differences is that Sharia banking rules forbid the payment of interest on loans of money. Since the bank cannot make money by charging interest on its loans, there are other rules which avoid this problem. In Sharia banking various other principles are used to share the profit and loss.

How Does a Sharia Loan Work?

To explain how a loan would work in accordance to Islamic law, we will use the example of a mortgage. If you were to apply for a Sharia mortgage, rather than loaning you the money to purchase your home the bank would instead buy the home from the seller and re-sell it to you at a profit. You would be allowed to buy the home from the bank in installments. There would be no penalties for late payment, because the bank’s profit would not be allowed to be made explicit. However, so that the bank can protect itself in the event that you decide not to pay, they can ask you to give them collateral. This is also the way that a Sharia bank would handle a car loan, by purchasing the vehicle first and then selling it to you.

Another interesting approach offered by some banks is known as Musharaka al-Mutanaqisa. This type of loan allows for you and the bank to purchase a property together at an agreed upon percentage. You then rent this property from the “partnership”. You and the bank share the proceeds from your rent according to the equity share in the property. Over time, you pay for the bank’s share of the property by paying periodic installments until eventually the full equity of the home is transferred over to you. If you default on this type of loan, both you and the bank will receive a proportion of the proceeds based on your current equity share.

Wadiah

Another aspect of Sharia banking is the practice of “wadiah”. There is no interest paid in the same way that regular banks do on savings accounts. However, it is acceptable for the bank to give its customers a “gift” known as a “hibah” after keeping their funds in the bank for a certain amount of time.

Each “Sharia” bank is governed by an official Sharia Advisory Board, which is made up of Islamic scholars, experts and clerics who will ensure that all of the bank’s practices are in compliance with Islamic law.

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