We have already talked about topics regarding finance and decentralized finance, alternative ways of making money work. Today, however, we want to show you how Islamic finance works, a financial activity that is constantly growing by about 20% per year.
The entire system must necessarily comply with Sharia, or Islamic Law, which is why certain businesses are allowed or prohibited. That’s also why many people ask themselves how do Islamic banks make money.
Introduction of Islamic Banking and fundamentals
Just like everything belonging to Islamic culture, Islamic Finance also respects the principles of the Qur’an. In this regard, the Qur’an prohibits increases (riba), or money earned through money – interest.
In short, the act of lending a certain amount of money in order to receive a percentage more in the following year is forbidden in the entire Muslim banking system.
In addition, investments in activities, companies or services that violate Islamic principles, such as the production of pork, alcohol and similar products, are also prohibited.
Speculation is also forbidden. Called maisir, this does not allow Islamic Finance companies to sign contracts whose future cannot be clearly predicted. Consequently, risk, or gharar, is totally banned. This includes derivatives, futures and short-selling assets.
One last but crucial principle of Islamic Finance is the encouragement of partnerships and collaborations. Two individuals or companies, in fact, must share both profits, risks and losses.
How can I buy a home within Islamic Finance?
Let’s say you want to buy a house. There are two alternatives:
Murabaha: the bank buys the house you want, reselling it to you at a slightly higher price. You, however, will have the option to pay in instalments.
Musharakah: the bank buys the house with you. You will give a certain amount of money equivalent to the bank’s share.
For example, Alrayanbank‘s services, unlike conventional financing to buy a property, do not involve any interest charges. Rather, they are based on joint properties. Each time you pay a monthly payment, you assimilate a share of the property, while still paying the bank for the share you own.
This is very different from a loan, where money is merely lent out and then paid back with interest that is sometimes too high.
What about other forms of investment?
Since Islamic Finance complies with Sharia, some of the conventional investment instruments cannot be used. Therefore, there are only two types of services available:
- Fixed return instruments
With equities it is possible to invest in businesses which, however, must not have anything to do with activities not foreseen by Sharia. Therefore, no tobacco, alcohol, gambling, interests, lending, pork and similar can be used as an investment.
Consequently, given the prohibition of loans, Islamic Finance does not have bonds, if not sukuk, or partial ownership of an asset.
You’ve surely realized that Islamic Finance is much different in some aspects to traditional finance. On some fronts it can be much more convenient, such as when buying a new home.
On others, however, it may not meet everyone’s needs, as it prohibits many forms of investment.
In these cases, differentiating between the various tools and services available online and offline can be a great way to mitigate risk and maximize gains.