Islamic vs conventional financing Posted on September 26, 2013 - - TopicsExpress

Islamic vs conventional financing Posted on September 26, 2013 - Featured, Investment. By Loanstreet Photo by Loanstreet Malaysia has one of the most advanced Islamic finance industries in the world. Since its initial introduction, Islamic financing products have evolved and matured to be comparable to and just as competitive as other conventional loan packages. But there are some key differences. Conventional financing principles In conventional financing, lenders lend to borrowers to make a profit from the interest charged on the principal amount. For property loans, borrowers pay an interest on the outstanding principal amount. Interest rates can be a fixed rate or based on a floating rate (e.g. BLR, KLIBOR). Payment is made over a set tenure by installments. A portion of each installment paid goes towards servicing the interest, while the remainder goes towards paying down the principal. Since the contract is not based on an absolute value (e.g. a sale price), the sooner the the borrower can pay down the principal, the cheaper the amount of interest paid. The loan contract for conventional financing is known as a loan facility agreement. Islamic Financing Principles Islamic financing avoids interest-based transactions (riba), and instead 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. Like conventional financing, profit rates can be a fixed rate, or based on a floating rate (e.g. BFR). The majority of Islamic home financing options in Malaysia today are based on the Bai Bithamin Ajil (BBA) concept. A small number of alternatives are based on the Musyarakah Mutanaqisah (MM) concept (which will not be covered in this article). BBA The principal amount, tenure and profit rate determines the “sale price” and the profit earned by the lender. Like conventional financing, payments are deferred over installments. The loan contract for BBA Islamic Financing is known as a sale and buy-back agreement. Benefits of Islamic financing over conventional financing As part of the Malaysian Government’s efforts to promote Islamic financing in general: For an indefinite amount of time, there will be a 20% stamp duty discount for Islamic loan agreement documents. Note: In conventional financing, there are only two legal documents necessary: the facility agreement and charge documents. But for Islamic financing, there are at least three (for some products four), which brings up the total legal costs. In cases of refinancing from conventional to Islamic packages, there will be a 100% stamp duty waiver on the existing refinance loan balance. This is not applicable to any amount over and above the existing refinance loan balance. Benefits of BBA Islamic financing For floating profit rates, profit rates are capped at a maximum. Conventional floating interest rates have no such cap. Late settlement of loans can incur lower charges than conventional loans as there is no concept of compounding interest calculation. However, in practice, other fees and charges may apply that could offset this benefit Benefits of conventional financing over Islamic financing For conventional loans, if a borrower alters the terms of the finance (eg. increases the facility amount), the loan facility agreement would only need to be up-stamped. For Islamic financing, a new sale and buy-back agreement (BBA) needs to be drawn up, making it more expensive. Islamic financing loans are difficult to restructure or refinance in cases of default. Your costs for early settlements, late payments or defaults are more straightforward in conventional financing contracts as compared to those for Islamic financing. Anyone (not just Muslims) can take up Islamic financing. But if your occupation is not deemed “halal”, there could be difficulty in obtaining the loan. With increasing maturity of Islamic finance, the differences between Islamic and conventional loan products have narrowed considerably. In another article, we explain about Islamic home loans in detail. If you are unsure whether to go with conventional or Islamic financing, make use of Loanstreet’s proprietary comparison wizard by selecting both Islamic and conventional options. This way, you can compare the best packages both options have to offer.