Definition, Principles, and Benefits of Islamic Financing

In recent years, more Indonesian customers are moving into Islamic financing institutions to assist their financial needs. Data on Indonesia’s Sharia Banking Statistics by the Financial Services Authority (OJK) shows that the number of customers of Sharia-based financing institutions reached nearly 36 million in January 2022. From this data alone, we can see how high the development potential of Sharia-based financing is in the country.

To understand the hype around Islamic financing, let’s read the details below!

Definition

Islamic financing refers to financing services based on Islamic law principles from the Quran or Hadith. From this distinction alone, we can see how different Sharia-based financing institutions are from conventional ones. Furthermore, conventional financing institutions operate under the existing Indonesian laws.

Sharia-based financing institutions also have different purposes. Whereas conventional financing institutions solely aim for profit, Sharia-based institutions aim for something else. The primary purpose of Sharia-based financing is conducting financial transactions based on Islamic values, avoiding interest (riba), excessive uncertainty (gharar), and overspeculation (maisir).

Principles

Sharia-based financing also has different principles from conventional financing. These principles are implemented in many types of agreements between the financing institution and customers. There are many principles in Sharia-based financing, but the most commonly used principles are:

1. Mudharabah

Mudharabah is an agreement between capital owners and managers with profit sharing based on an initial agreement. When a loss occurs, only the capital owner bears the loss. In the context of Sharia-based financing, customers act as capital owners while financing institutions act as fund managers.

2. Murabahah

Murabahah is a sale and purchase transaction between Sharia-based financing institutions and customers with a certain time limit. Murabahah is often also referred to as a sale and purchase agreement. In this case, Sharia-based financing institutions act as sellers while customers act as buyers. Payments are often made in installments.

3. Musyarakah

Musyarakah is a general form of business partnership based on the principle of profit sharing. The profits obtained will be shared according to previous agreements between all parties involved, while the loss burden will be calculated based on the proportion of capital invested. This transaction aims to increase the total value of assets owned jointly.

4. Wadiah

The Wadiah principle allows Sharia-based financing institutions to use funds deposited by customers with permission. However, conditions apply that the financing institution can return the funds in full to the owner.

Read also: 4 Islamic Finance Products You Can Offer for Customers

5. Ijarah

Ijarah involves providing services or services that will later be paid by the customer as a rental fee. In a Sharia-based banking environment, this principle is used in renting safe deposit boxes.

6. Salam

The salam principle in Islamic financing institutions refers to buying and selling transactions where the goods being traded are not yet available. An example is a customer who wants to buy goods that are still in the production stage. In practice, goods that will be given by customers to Sharia-based financing institutions will be resold in installments.

7. Istishna

Istishna can be interpreted as a buying and selling transaction with payments that can be paid in installments in several stages. However, the specifications of the goods being transacted must be clear and the agreed price must not change. This principle is often used in construction and manufacturing financing.

8. Qardh

Qardh is a form of borrowing money without additional compensation. However, Islamic financing institutions as lenders can ask for collateral for funds borrowed by customers. This principle is generally used only for urgent needs.

9. Hiwalah

Hiwalah can be interpreted as a transfer of debt from the party who owes it to another party who is responsible for the debt. In Sharia-based financing, this transaction is often used to help suppliers obtain capital to continue production.

10. Wakalah

In the context of financing, Wakalah is an agreement between capital owners and Islamic financing institutions to represent the implementation of a task per the customer’s request within a certain period.

Advantages

We’ve explained before how many Indonesian customers have begun to use Sharia-based financing institutions. What are the tangible benefits of such financing institutions in a society increasingly aware of such an economic system?

1. Interest-free

The first advantage of Sharia-based financing is to absence of interest. Sharia-based financial transactions are controlled by agreements aligning with Islamic economic principles and adjusted based on the customer’s needs. One example of this is murabahah. With this principle, the determined profit and price have already been fixed without additional interest.

2. Customers are your partners

In Islamic financing, customers are your partners. It means that the Sharia-based financing institutions and their customers must be on the same page to determine the kind of agreement they want to use. The agreement’s type is determined by the customer’s current financial state and assessment from the financing institutions.

Read also: 7 Differences between Islamic Finance and Conventional Finance

3. Fixed number of paid installments

The amount of principal installments that must be paid by customers is fixed. Why? At the beginning of the contract, the customer and the Islamic financing institution must agree on the number of installments and the profit margin paid. This is done because Sharia-based financing institutions adhere to a contract or agreement approach in their transaction activities.

Now, we can finally understand what Sharia-based financing institutions are and their principles and advantages. Despite their difference from conventional financing, the credit application process in Sharia-based financing institutions still requires verification from prospective customers.

To make the verification process more accurate, you can use the Multifinance Core Systems CONFINS system from AdIns. Everything from the digital signature, face recognition, credit scoring, and OCR for scanning identity cards are available in one single package of this system. Contact us through WhatsApp to try the demo for CONFINS, and offer the most practical credit application process in your Islamic financing institution only with the cutting-edge services from AdIns!