Islamic Financing is Expensive: True or Not?

Some say, Islamic financing is more expensive than conventional loan. So they made a choice based on what is cheap, convenient, and easy. But is that true? Is Islamic financing more expensive than conventional loan?

If enough people say it’s true, then it must be true. Right?

Nope! That’s not how truth works.

To know if something is true or not, you have to investigate it. So let’s investigate the question: is Islamic financing more expensive than conventional loan?

The answer to the question lies in the very basic of Islamic financing and conventional loan - how they make money.

Let’s start with conventional loan.

How Conventional Loan Makes Money

Conceptually, conventional loan is pretty straightforward: you ask the bank for money, the bank gives you money, and you pay the bank back with interest. Through interest, the bank makes money.

How much interest do you have to pay?

This is where things get interesting (pun intended). The interest rate is not fixed, because it is based on the base lending rate (BLR for short) determined by Bank Negara Malaysia (BNM). BLR can be higher or lower from the time you received the loan.

Essentially, you are gambling with how much you are paying at the end of the day because you can’t control or predict the BLR. If BLR goes down, then you are in luck. If BLR goes up, then your luck runs out apparently.

So you can’t definitively claim that conventional loan is cheaper by default, because you literally don’t know how much you are paying the bank. You could be paying more. You could be paying less. But the uncertainty is certainly discomforting.

Imagine the case when you choose conventional loan to pay for your house. A typical house loan can last 30 years. Within that long period of time, can you definitively say that the BLR will go down in your favour? Or at the very least, can you ensure that the BLR stays the same from the moment you got the loan?

I’m not saying conventional loan is more expensive. I’m also not saying that it’s cheap. I’m simply saying you don’t know how much you are paying at the end.

That’s the reality of conventional loan. But what about Islamic financing?

How Islamic Financing Makes Money

Yes, Islamic finance institutions can make money. Remember, it is a business and not a charity. But how do they make money from Islamic financing?
First of all, it is important to note that Islamic financing is not a loan. Technically, you are not asking for money. Islamic financing is a business deal made between the Islamic finance institution and you, their client.

Say you want to buy a house and you opted for Islamic financing. What the institution does is they buy the house and then sell it to you for a higher price. Why higher price? Because it is a business deal - a typical buy and sell situation.

The difference between the price the institution paid to buy the house and the price the institution sells the house to you is the profit margin. That is how an Islamic finance institution makes money, from profit.

But how much is the profit? How much are you paying extra? Islamic financing uses base financing rate (BFR), which is similar to BLR in principle but used to differentiate between a loan and financing.

Unlike conventional loan, the profit is fixed at the time you sign the trading contract with an Islamic finance institution. So from the beginning, you know exactly how much you are paying at the end of the contract.

The price you pay is not going to suddenly go up or down.

So, does that mean Islamic financing is cheaper? If you take into account the certainty and the security you get from knowing how much you are paying, then I can safely say that it is cheaper. You are not gambling anything and leave things to chance.

Perhaps if the BFR is low, then you could possible be paying less with conventional loan. But, you never know when that will happen. In fact, you never know if it will happen at all! There is a chance that you will be paying more.

So, What Now?

In the end, it is a personal choice. Do you want to know for certain how much you are paying with Islamic financing, or do you want to leave it to chance and see how it goes with conventional loan?

Whatever the choice is, be sure to do your due diligence. You have to gain more knowledge and understanding about the subject matter, and then make a decision - a well-informed decision.

Thankfully, we have organizations like IBFIM, that specializes in Islamic finance training in the effort to increase awareness and the number of qualified professionals in the community.

Check them out here: ibfimonline.com/about-us