“…they (unbelievers, hypocrites) say: “Trading is only like ribâ (usury; interest),” whereas ALLAH  has permitted trading and forbidden ribâ . – The Quran, Chapter 2, verse 275.

This verse of the Quran clearly sets the guideline for a Muslim about the forbidden nature of riba or interest and usury. The following explanation briefly introduces the difference between conventional and Islamic finance which APPEAR to be the same, but are NOT the same. Understanding the difference between these is critical for Muslims in order to prevent committing sin in matters of finance.

What is the difference between Islamic and conventional financing? Both are modes of finance, but very distinct in the nature of the contract, relationship and how the parties deal with each other in hardship/losses. This article provides a foundation to understanding the difference.

Finance Institutions have the right to make a profit in their business dealings. As Islam promotes harmony and fair dealings in all relationships – family, neighbors, business dealings, etc., it regards interest-based loan contracts as abusive and therefore not permitted in a religious context. Conventional finance is a debt-based contract/agreement. The “financier” will give $X to the client, so the client can further utilize the funds to purchase an asset/commodity. Example a car, home, etc. The relationship is based on the loan to be paid back over an agreed amount of time PLUS a surplus amount as profit to the financier. This is what we call “interest”. However the question is – is this what we are trying to avoid – paying the surplus amount? If that is the case, then are we suggesting all finance companies around the world should only take back what they advanced (i.e. principle balance)? Then we should also declare them to be non-profit organizations and operate as charities. Doesn’t make sense, does it? Therefore we can agree that the “surplus” amount (in the example above this references to the “interest” amount paid back) is not really the issue at hand. So what is the issue?

The issue actually arises at the point of the “agreement”. The agreement is based essentially on making the money being lent itself as an asset/commodity. What is money? – it’s just a piece of paper created in a machine by the Treasury Dept. It is not a physical asset/commodity itself. In Islam – money is a means of exchange/assignment of value to an asset/commodity, not an asset/commodity itself. This distinguishing factor is very important to understand the fundamentals of the argument being discussed.

An Islamic bank will also help finance a car, home, etc. just like the conventional bank. However instead of advancing money to the client, the Islamic bank will actively and directly participate in purchasing some/all shares (depends on the mode of financing, which we’ll discuss at a later time) in the asset/commodity. Then after taking some/all ownership of the asset/commodity, the Islamic bank will allow the client to use its “shares” for the intended purpose. Based on an agreement the client buys the Islamic bank’s invested shares plus pay a competitive and comparable profit in lieu of interest as charged by the conventional banks.

It could very well be that in both conventional and Islamic financing – the amount paid at the end could exactly be the same amount. But as discussed above, this is not what determines for a contract to be compliant to Islamic finance rules. It is the nature of the contract, relationship and how the parties deal with each other in hardship/losses. In conventional finance since the banks will have no physical ownership of the asset/commodity itself – they do not have to worry about any losses. If the asset/commodity is in a total loss, the client still “owes” the loan/interest to the conventional bank. Therefore it can be concluded that every conventional loan finance contract is of a “recourse” in nature – meaning the bank has the right to come after the debtor for any balance left on the initial loan advanced and any interest/expenses incurred due to the devalue/forfeiture of the asset/commodity.

However an Islamic bank who actively owns the physical asset/commodity itself – must share/suffer any losses to its ownership/investment if any disaster strikes. Islamic finance is simply a “non-recourse” contract, exactly the opposite of conventional finance. Here the client walks away absorbing, at most, any loss on their shares invested only. They are not responsible for the loss on the Islamic bank’s shares – regardless of the reason for the loss.

This is why ALLAH SWT has permitted trading and prohibited usury/interest, as Islam promotes harmony and fair dealings in all relationships – family, neighbors, business dealings, etc.

In the future we’ll discuss briefly on the different modes/models in Islamic Financing. Which one is better, than the other? As a customer how do you know the model/product being offered complies with Islamic finance rules and regulations?