From expected profit rate to home purchase plans, there are a number of terms you will have to know if you are to consider a provider which complies with Islamic banking principles. Also known as Shari’ah-compliant banking, we explain below how this works and what you will need to know when considering savings, mortgages, and other personal finance products.
When looking for a savings account to suit your needs, you have probably come across the term “expected profit”. Used as a substitute for interest, this is the key difference between Shari’ah-compliant providers and other financing options.
An expected profit rate is the likely money you will earn over your investment period. It operates like interest, but it is calculated differently in order to comply with Shari’ah banking regulations.
Under Shari’ah law, interest is forbidden. It is seen as a means to promote unfairness in society, and is also known as “riba”.
Therefore, while non-Islamic banks pay interest on your savings deposit, a Shari’ah-compliant bank will instead use your funds to buy and sell different assets. This will generate a “profit” which will then be used to fund your rate.
These assets are also specific, with Shari’ah-compliant banking only funding investments it deems as ethical. This means Islamic banks will not buy assets which do not adhere to the values of Islam, such as alcohol, pornography, gambling or tobacco, to name a few. In addition, they will not invest in other trading strategies such as shorting, options, and currency options.
There is a certain level of risk with this type of investment and in theory a bank can fail to match your agreed expected profit rate. However, such instances are scarce, with banks such as Al Rayan and Gatehouse Bank yet to default on their agreed expected profit rate. For Al Rayan, there are other investments which have exceeded the agreed upon expected profit rate, which meant some savers were paid out more.
If, for whatever reason, the bank does not reach its expected profit rate then savers have the option to withdraw their investments plus any profit earned to date or accept a lower expected profit rate. Since UK regulation states that savings accounts must have their capital guaranteed, savers will never lose their deposit.
It is key to remember that Islamic banks adhere to the same regulations as other providers in the UK. All Shari’ah-compliant banks that are authorised in the UK are covered under the Financial Services Compensation Scheme, whereby the first £85,000 of savings per person is protected in the event a bank fails or goes bankrupt.
No, Shari’ah-compliant banks and savings accounts are open to all savers in exactly the same way as other savings accounts.
Shari’ah-compliant banks offer a range of ISAs if you are looking for a tax-free alternative for your savings. Operating in much the same way as a savings account, cash ISAs will contain an expected profit rate to comply with Shari’ah law, which will be paid tax-free.
Shari’ah-compliant stocks & shares ISAs are also available to the public. As mentioned above, these funds will be invested into Shari’ah-compliant ethical practices, not companies involved in practices such as alcohol and arms.
In addition to savings products, some Shari’ah-compliant providers also offer home purchase plans, which function like mortgages. This is because a traditional bank or building society will earn money from their mortgage lending activities by charging a rate of interest, and as mentioned above, this is prohibited under Islamic finance principles.
In order to finance your home, a home purchase plan can function in different ways. All of these require the bank or building society to buy the property and the customer then pays “rent” to the lender, effectively buying it back from the bank over time.
Under Ijara, which functions like a lease, the bank or building society purchases your chosen property under its own name. As a customer, you will pay the lender a fixed “rent” each month over a certain period. This money is put aside, and once it has accumulated to pay off the house price then it is used to transfer the property in your name.
For Musharaka home purchase plans, the customer and provider will be joint holders of the property. However, when the customer pays “rent” each month, it will reduce the provider’s share of the property and thus the amount of “rent” they pay each month.
Finally, under a Murabaha agreement, the lender will purchase your chosen property but immediately sell it to you at a higher price, thus making a profit. Therefore, each month the customer will have to pay back a fixed-rate rent which factors in this profit. How this differs from Ijara home purchase plans is that the property will gradually be transferred into your name, while under Ijara it will only be transferred once you have paid the value of the property.
These home purchase plans almost act like a regular mortgage, with a payment being made over time until the customer owns the property outright. However, the key difference is that Shari’ah-compliant banks are not making money from other money. Under Shari’ah law, this is seen as a profit from a purchase.
There are some specialist Islamic banks that only offer Shari’ah-compliant services. There are also some banks that offer Shari’ah-compliant accounts as part of their savings range. These are some of the banks offering Shari’ah-compliant savings at the moment:
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.