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What is an Islamic finance loan?
Islamic finance (halal or halaal finance) is a way of banking, lending and borrowing money — that is consistent with the principles of Islamic or sharia law.
These principles include the avoidance of financial activities seen as forbidden (haram) — Including things like riba and usury. Ultimately, this means that sharia compliant loan providers — do not charge interest on any amount borrowed and do not fund businesses involved in things like alcohol, betting etc.
In Nigeria, Kano is the center of Islamic finance — with a number of Islamic banks operating in the state.
Islamic finance — considerations
Central to Islamic finance is the concept that, as money has no intrinsic value, one should not be able to make money from money directly. Money is simply seen as a medium of exchange and as such — charging interest is forbidden.
With Islamic finance, wealth can only be created by partaking in legitimate trade activities and investing in assets. In other words — money must be used in productive ways.
Accordingly, Islamic finance is primarily based on trading — where risks are shared between the person providing the capital and the person with the expertise. Thus both profits and losses are shared.
How does Islamic finance work?
A business that is interested in a Islamic finance product, may approach an Islamic bank or other sharia compliant financial institution. These Islamic banks, can finance your business with a variety of different financial products — depending on what you specifically need.
These products can be used for working capital, project financing, equipment lease, equity-based finance, letters of credit and more. These products will all be structured in ways that adhere to the principles of Islamic banking, namely: the sharing of profits and losses, and the ban on the collection and payment of interest.
Types of Islamic finance products
Ijara works as a leasing arrangement — where a lender can buy a product and then lease it out to you. As an example, this can be used to acquire a vehicle or plant machinery.
Here a bank provides you with goods for resale — at a price that includes a margin above costs. This allows a business to buy something and pay in installments. For example, financing commercial mortgages.
This is a joint venture, where a bank and a customer both contribute funds — for either an investment or purchasing an asset. The profits (and the risks) are shared proportionally.
Wakala refers to a contract where a customer appoints an agent, to complete a defined legal action, on his/her behalf. This product facilitates economic exchange, so for example a bank providing a letter of credit — for import or export.
Benefits of Islamic finance
- Interest free (no interest to pay)
- Promotes financial justice — risks and rewards are shared
- Financial inclusion — encourages un-banked Muslims to benefit from finance
- Reduces impact of harmful practices — alcohol, betting etc.
- Promotes financial stability — less risk and more stable returns
- Accelerates economic development — an alternative form of financing
Limitations of Islamic finance
- High costs — as documentation is often tailor made to the transaction
- Longer application processes — Islamic banks do more due diligence
- Not many Islamic finance providers
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