Conventional vs. Islamic Home Loans

The principles of Conventional Financing involve lending money to borrowers with the goal of earning a profit from the interest charged on the principal amount. Borrowers pay interest on the outstanding principal amount, and the interest rate may be fixed or based on a floating rate, such as BLR or KLIBOR. Payment is made over a predetermined period by installments, with a portion of each installment used to service the interest and the remainder used to pay down the principal. The loan contract for Conventional Financing is called a Loan Facility Agreement. The sooner the borrower can pay down the principal, the less interest they will pay.

Islamic Financing operates under the principle of avoiding interest-based transactions (riba) and instead relies on the concept of buying something on the borrower's behalf and selling it back to them at a profit. The contract defines a profit rate in place of interest, which can be fixed or based on a floating rate like BFR. The most common Islamic home financing option in Malaysia is based on the Bai Bithamin Ajil (BBA) concept, although some alternatives use the Musyarakah Mutanaqisah (MM) concept.

Under BBA Islamic Financing, the principal amount, tenure, and profit rate determine the sale price and the lender's profit. Like Conventional Financing, payments are deferred over installments, and the loan contract is known as a Sale and Buy-Back Agreement. Musyarakah Mutanaqisah is a type of partnership in which one partner gradually purchases the equity share of the other partner until they become the sole owner of the asset or business venture.

For floating profit rates, BBA Islamic Financing caps profit rates at a maximum, while late settlement of loans can result in lower charges than Conventional loans. However, Islamic financing has difficulty in restructuring or refinancing in case of default, and the costs for early settlements, late payments, or defaults are more transparent in Conventional Financing contracts.

Overall, the differences between Islamic and Conventional loan products have narrowed considerably as Islamic finance has matured.

Anyone, regardless of their religion, can take up Islamic financing, although a poor credit background could make obtaining a loan difficult.

More information about Islamic Home Loans can be found in another article.

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