1

THEORY RIBA: CONVENTIONAL PERSONAL FINANCING VS ISLAMIC PERSONAL FINANCING

THEORY OF RIBA CONVENTIONAL PERSNAL FINANCING

ISLAMIC PERSONAL FINANCING

Definition

Prohibition from Hadith

Stages of Revelation from al-Quran

Types and Classification

Theory

Insurance

Retirement Planning

Money Management

Investments

Theory

Murabahah

Tawarruq

Bai’ `Inah

Al-Ijarah

INTRODUCTION

“Allah has permitted trade and has forbidden riba”

Surah 2:275

Prohibition of riba is no doubt and it is the most important feature in Islamic economics.

Riba, interest, or usury is strictly prohibited in Islam. As dealing with Riba-based

transactions means declaring war with Allah Almighty and His Messenger (Muhammad,

peace be upon him) Surah Al-Baqarah (2:279). Riba well-define in Quranic is increase, grow,

multiply and climb. However, in economic context, it is generally known as a contractual

increase on loaned money or commodity. In Islamic terminology riba means as increase or

excess over principle or called as stipulated, force or obligatory surplus on debt. In financing

framework, riba is a loan with condition that the borrower will return to lender more than and

better than the quantity borrowed. There are two type of riba which are riba al-fadl and al-

nasiah. The theory of riba will be explained broadly in this task and how that practicing may

result in daily life. This task examine the principles of riba and how it fits within the realm of

Islamic economics and banking, as it is exemplified by the Prophet SAW in his Sunnah and

as it is described in the Holy Qur’an. Recognizing financing is one of the needs of

businesses, that financing is intended to benefit both parties. In this task, it will expose the

concept of riba in practicing in Islamic institution and conversational institution and the way

of institutions determined rate for financing. This work may be attributed to the

reinterpretation of the riba doctrine and reconsideration of profit theory in Islamic

perspective. Besides that, it is important to known the features of Islamic financing and

conversional financing in order to distinguish the activity between both institution.

2

1.0 Theory of Riba

1.1 Definition of Riba

Riba literally means excess, increase, expansion and growth. The word means

increase and mean addition to something. The excess originates either in the thing itself or an

increase in exchange or sale of money as the sale of money as the sale of one dirham for two

dirhams or of commodities as in cases of barter of a measure for more of the same

merchandise. It is however, not every increase or growth which has been prohibited in Islam.

In Shariah, Riba technically refers to the premium that must be paid by the borrower to the

lender along with the principal amount as the condition for the loan or for an extension in its

maturity. Riba has the same meaning and import as interest in accordance with the consensus

of all the jurists without any exception. Some Islamic scholar has their own opinion on the

concept of Riba. Nabil Salih said, Riba is an unlawful gain derived from the quantitative

inequality of the counter values in any transaction while Abu A’la al-Maududi said, it is a

predetermine excess or surplus over and above the loans received by the creditors

conditionally in relation with a specific period.

1.2 Types and Classification of Riba

Riba is classified into two categories. First, Riba al-Nasi’ah is where the specified

increase is in return for postponement of the payment. The term Nasi’ah means to postpone,

defer, or wait and refers to the time that is allowed for the borrower to repay the loan in

return for the premium. Second, Riba al-Fadl is the excess over and above the loan paid in

kind. It lies in the payment of an addition by the debtor to the creditor in exchange of

commodities of the same kind. Abu Said al-Khurdi said: “the Prophet Muhammad (saw) has

said that gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates

and salt for salt, can be traded if and only if they are in the same quantity and that is should

be hand to hand. If someone gives more or takes, then he is engaged in riba and accordingly

has committed a sin.” To sum up, Riba al-Nasi’ah and Riba al-Fadl are both covered by the

verse, “Allah has allowed trade and prohibited riba” (2:275), while Riba-al Nasi’ah relates to 3

loans and Riba al-Fadl relates to trade. Although trade is allowed, it does not mean that

everything in trade is allowed.

1.3 Stages of Revelation from the Quranic overview

First stage : al-Rum,39

Translation:

“That which ye Lay out for increase through the property of (other) people, will have

no increase with Allah. But that which ye Lay out for charity, seeking the

countenance of Allah, (will increase): it is these who will get a recompense

multiplied.”

Second stage: al-Nisa’,161

Translation:

That they took usury, though They were forbidden; and that They devoured men’s

substances wrongfully; we have prepared for those among them who reject Faith a

grievous punishment.

Third stage: Ali Imran,130

Translation:

O ye who believe! devour not usury, doubled and multiplied; but fear Allah. That ye

may (really) prosper.

Fourth stage: al-Baqarah,275-281

Translation:

Those who devour usury will not stand except As stand one whom the evil one by His

touch hath driven to madness. That is because They say: “Trade is like usury,” but

Allah hath permitted trade and forbidden usury. Those who after receiving direction

from their Lord, desist, shall be pardoned for the past; their case is for Allah (to

judge); but those who repeat (the offence) are companions of the Fire: They will

abide therein (for ever).

4

1.4 Prohibition of Riba in the Hadith

Jabir reported: The Prophet (s.a.w) cursed the receiver and the payer of interest, the one who

records it (the contract) and two witnesses to the transaction and said, “They are all alike(in

guilty).”

Ubadah Ibnu al-Samit reported a hadith from the Prophet s.a.w: “Gold for gold, silver for

silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal for

equal, and hand to hand. If the commodities differ, then you may sell as you wish provided

that (the exchange) is hand to hand.

Abu Hurayrah (ra) narrated that tha Prophet (s.a.w) said: “God would not allowed four

persons to enter paradise or to taste His blessing: he who drinks wine, he ho takes riba, he

who usurps an orphan property without right and he who is undutiful to his parents.”

5

2.0 Conventional Personal Finance

2.1 Theory of Conventional Personal Finance

The academic discipline of finance is divided into three areas which are personal finance,

corporate finance and public finance. Corporate finance area includes the study of matters

regarding finances of for-profit organizations for example, business entities and corporations.

Public finance area deals with the matters which relate to financial affairs of domestic and

international governments and other public entities. This assignment is focusing on personal

finance which has smaller scope of study compared to corporate finance and public finance.

Personal finance considers the finances of individuals and families concerning household income

and expenses, credit and debt management, saving and investing, and income security in later

life.1 This is from conventional perspective since this is the general or customary practice mostly

in this world.

Examples of questions involving personal finance matter is how much money do I need

to buy a house? And how can I get the money? One may think of making loan in order for him or

her to have a house. Both the two questions and the person’s decision to make a loan are the

matters of personal finance.

For a clearer view of personal finance, it could be defined as the study of personal and

family resources considered important in achieving financial success; it involves how people

spend, save, protect, and invest their financial resources.2 Personal finance also includes career

planning, credit cards, and risk management. People who have knowledge about personal finance

could be success in facing financial challenges.

The foundation of financial success is the use of regular income to provide basic lifestyle

and savings. Apart from regular income, people also might need savings account, insurance

protection, and employee benefits for a better life. From those needs, people will set their

financial goals. They would manage their expenditures such as housing expenses, insurance

1 http://en.wikipedia.org/wiki/Finance

2 Garman & Forgue. 2010 Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10th edition.

p. 46

expenses and contingencies. They also would handle their credit cards, installment loans, and

savings account, and invest in stocks and bonds, and retirement plans. All of these are to ensure

that they will achieve financial success.

Personal financial management includes monetary asset management. There are three

tools of monetary asset management which are; 1) low-cost, interest-earning checking accounts,

2) interest-earning savings accounts, and 3) money market accounts. These tools might be

prohibited for Muslims because they involve usury. However, there are alternatives for them

which were being discussed in Islamic personal finance section of this assignment. Topics

covered by personal finance would be discussed briefly in the following paragraphs. The

included topics are money management, income and asset protection, investments, and

retirement planning.

2.1.1 Money Management

A person should build and maintain good credit. Credit could be described as an

arrangement in which goods, services, or money is received in exchange for a promise to repay

at a future date.3 It could be in the form of loan or credit card. The worse the credit history of a

person is, the harder for him to obtain credit which also depending on economy condition at the

circumstance. People with no credit history also could not easily obtain credit. Among the

advantages of credit includes, purchases become easier, paying emergencies expenses, to buy an

expensive product immediately and paying for education. The disadvantages of using credit

include reduced financial flexibility, results in overspending, and need to pay for costly interest

expense.

Consumer credit is non-business debt used by consumers for expenditures other than

home mortgages.4 There are two types of consumer credit which are installment credit and non-

installment credit. In installment credit, a borrower should pay the amount owed to the lender

plus interest in a specific number of equal payments. For example, a RM18, 000 car loan might

3 Garman & Forgue. 2010 Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10th edition.

p. 168

4 Garman & Forgue. 2010. Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10 th edition.

p. 1947

require monthly payments of RM105 for 60 months at seven percent interest. Non-installment

credit requires the borrower to pay the amount owed for full plus interest. Examples of non-

installment credit are, single payment loan, credit cards, and service credit.

Credit card allows the borrower to pay in full at any time or carry forward a balance

owed from month to month. If the borrower chooses to carry forward the amount owed, a

minimum payment must be made to cover the interest and a small payment on the amount owed.

If the minimum payment is not received at the due date, the borrower could be declared as

default. One should manage his or her credit card wisely to avoid being declared as default or

being a bankrupt person.

Consumer installment loan could be obtained in two ways; cash loan and purchase loan.

When a person borrows cash to buy something it is called cash loan. When a consumer

purchases something on credit it is called purchase loan. Installment loan could be secured or

unsecured. A secured loan requires a cosignor in the contract. If the original borrower fails to pay

the loan, the responsibility falls on the cosignor. A secured loan also could be in the form where

an asset is pledged as collateral upon the loan. Unsecured installment loan is only backed up by

the borrower’s signature which reflects his agreement to repay the loan.

For a good money management, one should make a thorough analysis before obtaining

durable goods or expensive goods such as car and houses. A person should compare which

sources of loan provide the lowest annual percentage rate of interest, whether payment of the

loan affects negatively his income or does he is affordable to make a loan.

2.1.2 Income and Asset Protection

To achieve financial success, a person should take into consideration any losses that

might occur in his life. The losses could be accidents, injury, illness, death, or damage of

property. Therefore, as a protection, one should invest in insurance. Insurance is a mechanism for

transferring and reducing pure risk through which a large number of individuals share in the

financial losses suffered by members of the group as a whole.5 Insurance is divided into two

5 Garman & Forgue. 2010. Personal Finance. USA: Joe Sabatino South-western Cengage Learning . 10 th edition.

p. 2888

types which are property insurance and liability insurance. Property insurance is a protection for

financial losses resulting from damages of property while liability insurance is a protection for

financial losses suffered by others. There are many examples of insurance such as home

insurance, automobile insurance, health insurance, and life insurance.

2.1.3 Investments

Investing is taking some of the money you are saving and putting it to work so that it

makes you even more money while savings is the accumulation of excess funds by intentionally

spending less than you earn.6 People typically make investments in securities which include

stocks, bonds, and mutual funds. In spite of return that will be obtained by an investor from the

investments he made, he also could bear investment risks such as market risk, economic

meltdown, and business failure risk.

Stocks are shares of ownership in the assets and earnings of a business corporation.7

Stocks have two classes which are common stocks and preference stocks. Dividend received by

the common stockholders will not be the same for each payment period since it depends on the

profitability of the invested corporation. Otherwise, preference stockholders receive fixed

amount of dividend for every payment period. In other words, they have priority to receive

dividend.

Bonds are different from stocks. If a person invests in bonds, he actually lends money to

a corporation in exchange for series of interest payment by the corporation and the payment of

the principal value of the bond at the maturity date.

Mutual fund is an investment company that pools funds obtained by selling shares to

investors and makes investments to achieve the financial goal of income or growth. The figure

below depicts the concept of mutual fund (this figure is also extracted from Garman & Forgue

6 Garman & Forgue. 2010. Personal Finance USA: Joe Sabatino South-western Cengage Learning 10 th edition p.

376

7 Garman & Forgue. 2010. Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10 th edition.

p. 4119

Personal Finance 10th edition 2010 p. 456. However, the pictures used are not exactly the

same).

2.1.4 Retirement Planning

Retirement is the time in life when the major sources of income change from earned

income to employer-based retirement benefits, private savings, and investments, income for

social security, and perhaps part-time employment.8 A person who is thinking of his later life

financial security would make an investment now so that he could have a desired amount of

money continuously several years from now. This is because people cannot work forever due to

the process of aging and disabilities in old time.

2.2 Conclusion for Conventional Personal Finance

Generally, from the theory of conventional personal finance above, it can be concluded

that for to achieve financial success in life, a person should have the knowledge of personal

8 Garman & Forgue. 2010. Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10th edition

p. 50810

INVESTORSMUTUAL FUND

(INVESTMENT COMPANY)

A DIVERSIFIED PORTFOLIO OF

SECURITIES

Purchase shares in

Purchase shares in

finance. This is to make sure that the person would not make a wrong decision regarding

financial affairs in his life.

Another important thing to be considered is the concept of time value of money. It is an

inherent element in finance. This means, the concept applies in personal finance too. People will

always apply time value of money calculations in making financial decisions. It is the most

important concept in finance especially in loans and investments. In this concept, a dollar today

will not equivalent to a dollar in the next few years. One thing that should be concern of in the

time value of money concept is compounding. It can be described as earning interest on interest.

This is what is forbidden in Islam which is referred to as riba al-nasiah.

11

3.0 Islamic Personal Financing

Personal financing is the application of the principles of finance to the monetary

decisions of an individual or family unit. It addresses the ways in which individuals or families

obtain, budget, save, and spend monetary resources over time, taking into account various

financial risks and future life events.9 However, the corruptions and high interest on conventional

system of personal financing had opened public’s eyes to change their trust to Islamic Personal

Financing.is Islamic Personal Financing differs from Conventional Personal Financing? Yes, of

course. Among the differences are existence of riba, existence of guarantor and others (the

differences will be discussed in the next sub-topic).

Before we go deeper, let’s define the meaning of Personal Financing in Islamic

perspective. Islamic Personal Financing is fund or loan provided to certain individual under

certain rules and regulations by using several principles according to Shariah. This Islamic

Personal Financing is widely accepted by people in the world, not only Muslim but also Non-

Muslim since it is better than Conventional Personal Financing. Islamic Personal Financing is

conducted based on several principles, which are:

1. Murabahah Principles

Murabahah is a particular kind of sale, compliant with shariah, where the seller

expressly mentions the cost he has incurred on the commodities for sale and sells it to

another person by adding some profit or mark-up thereon which is known to the buyer.10

It is applied to personal financing in term of goods and used when used when user have

identified an end-user asset for their needs. The break-up of cost and profit will be

disclosed to user or customer. Among the goods provided under Murabahah Principles

are motorcycle, tools and machinery, household furniture and others. The flow of

transaction as follow:

9 http://en.wikipedia.org/wiki/Personal_finance

10 http://en.wikipedia.org/wiki/Personal_finance12

SELLER cash BANK deferred payment USER/CUSTOMER

2. Ijarah Principles

Generally, Ijarah concept means selling the benefit of use or service for a fixed

price or wage. Under this concept, the Bank makes available to the customer the use of

service of assets or equipment such as plant, office automation, motor vehicle for a fixed

period and price.11 In addition, other services provided under Ijarah Principles are

educational fees, marriage and wedding expenditure, residential accommodation and

rental payments. The flow of transaction as follow:

SERVICE PROVIDER cash BANK deferred payment USER/CUSTOMER

3. Tawarruq Principles

Tawarruq come from the root word “al-wariq” which means gold or dirham or

metal. Technically, tawarruq was defined as a transaction where one party buys some

goods on credit at a marked-up price and sells the same at a lesser value for the purpose

of getting cash. The purpose of this transaction is not the possession of the goods, but the

obtainment of liquidity.12 In general, tawarruq is conducted by following the above

method:

11http://en.wikipedia.org/wiki/Islamic_banking

12http://azamlaw.com/index.php?p=article00113

Moreover, tawarruq is divided into classical or real tawarruq and organized or managed

tawarruq. Classical or real tawarruq is a system where financier sells the goods to the

mutawarriq, who then dispose the goods in the open market. On the other hand, organized or

managed tawarruq is a system where financier manages the tawarruq process by selling goods to

mutawarriq, and then financier appoint mutawarriq agent to sell the goods on his behalf in the

open market. In term of permissibility, Fiqh Academy of the Organisation of Islamic Conference

(OIC Fiqh Academy) by its resolution held that classical tawarruq is permissible, but organized

tawarruq is prohibited.

14

Example of product structure guideline:

*http://www.bankislam.com.my/en/Pages/ShariahConcept.aspx?

tabs=3&mlink=PersonalFinancing

4. Bai’ ‘Inah Principles

Bai' ‘inah is a financing facility with the underlying buy and sell transactions

between the financier and the customer where the financier buys an asset from the

customer on spot basis. Subsequently the asset is sold to the customer on a deferred-

payment basis and the price is payable in installments. It can be applied for all things

15

except ribawi items like gold and silver. In addition, the sale contract must be separated.

The flow of transaction as follow:

Buy on cash

FINANCIE/BANK buy on deferred payment CUSTOMER

In term of permissibility, Shariah Advisory Council of Bank Negara Malaysia in

their 8th meeting held that Bai’ ‘Inah is permissible as long as it is done in accordance

with the guidelines and follows the view from Syafi’I’s Scholar. Besides that, other

Scholars like Hanafi, Zahiri, Imam Abu Yusuf and Imam Muhammad also permitted Bai’

‘Inah.

As a conclusion, Islamic Personal Financing is permitted in Islam since it is not

included interest or riba as their mark-up price and not required a guarantor to guarantee

a loan which prohibited by Islam. So, as a Muslim, the decision is on our hand. Whether

to choose the Conventional Personal Financing which is prohibited by Islam, or Islamic

Personal Financing which is permitted in Islam.

16

4.0 Differences between Conventional Personal Financing and Islamic

Personal Financing

Conventional Personal Financing and Islamic Personal Financing is a system which

manage all people financing but there are has differences in both these management of financing.

Islamic personal financing is a method of financing which is to get money complying with

Shari`ah Law which use Islamic financial transactions like murabahah, bai’ `inah, al-ijarah,

tawarruq. Conventional Personal Financing is a method of financing not under shari`ah which

use the term ‘interest’ to make profit or money. However, there are very much different between

Conventional Personal Financing systems and Islamic Personal financing systems. The

differences of both of these personal financing is as follows:

NO. CONVENTIONAL PERSONAL

FINANCING

NO. ISLAMIC PERSONAL

FINANCING

1. Conventional Personal Financing based

on fully manmade principles

1. Islamic Personal Financing based on

the Islamic perspective

2. It can be charge additional money called

riba (penalty and compounded interest)

in case of defaulters

3. No provision to charge any extra

money from the defaulters.

4. In conventional personal financing, the

investor is assured of predetermined rate

of interest

4. Islamic personal financing, it

promotes risk sharing between

provider of capital and the user of

funds.

5. It aims at maximizing profit without any

restriction

5. It also aims at maximizing profit but

subject to shari`ah restrictions

6. For interest-based conventional personal

financing, borrowing from the money

market is relatively easier.

6. For the Islamic Personal Financing, it

must be based on a shari`ah approved

underlying transaction17

7. A conventional personal financing has to

guarantee all its deposits.

7. Islamic personal financing can give

guarantee deposits for deposit

account based on the principles in

Islamic perspectives

8. The status of a conventional personal

financing in relation to its clients is that

of creditor and debtors.

8. The status of Islamic personal

financing in relation to its clients is

that of partners, investors and trader,

buyer and seller.

9 In conventional personal financing, it is

very often it results in the finance own

interest not take care about the public

interest It makes no effort to ensure

growth with equity.

9 It gives due importance to the public

interest. Its ultimate aim is to ensure

growth with equity.

10. Lending money and getting it back with

compounding interest is the essential

function of the conventional personal

financing

10. Participation in partnership business

is the fundamental function of the

Islamic personal financing.

11. In conventional personal financing, it

not concerned about unfair or

exploitative in the financial world

11. To get rid of any unjustified or

exploitative financial situation,

product or service, not just in a loan

transaction but in any bits that are

unfair or exploitative in the financial

world.

12. High profit rate 12. Low profit rate

18

CONCLUSION

Nowadays, riba is a common element in practicing transaction. It may arise in various ways

either in banking institution or exchange of good. The conservative view is that in addition to

usury or bank interest or both, riba also includes all forms of economic exploitation of the poor

by the rich like profiteering and paying of subsistence wages to laborers. Riba is divided into two

types which are riba al-fadl and riba al-nasiah. Riba fadl is an increase or excess value in

exchange or sale of commodity accrues to the owner (lender) without giving in return any

equivalent counter value. Meanwhile Riba al- nasiah is an increase for repayment deferment in

contract. Riba which relate most with personal financing is riba al-nasiah. The scope of personal

financing includes matters regarding household income and expenses, credit and debt

management, saving and investing, and income security in future life. In Islamic banking, the

basic aim is to perform interest free activities based on principles of shari`ah and bring halal

concept when dealing transaction. The most important feature of Islamic banking is sharing of

risk among the investor, the bank and the borrower. Islamic personal financing introduced the

concept of murabahah, ijarah, tawarruq, and bai’inah. Murabahah means a contract between a

bank and its client, by which the bank purchases goods and then sells them to the client at a cost

that includes a profit margin. The contract requires specific installment payments to the bank.

Tawarruq is a transaction where one party buys some goods on credit at a marked-up price and

sells the same at a lesser value for the purpose of getting cash. Bai’inah is a seller sells his or her

asset to buyer on credit. Then, a buyer resells the asset to first seller on cash basis at a cheaper

price from the first seller. The most differences between conventional and Islamic financing is

conventional financing may maximize profit without any restriction while in Islamic financing, it

allow to maximize profit but limited based on shari`ah principles. Therefore, it is important to

society to acknowledge the concept bring by Islamic principle in order to distinguish with

conventional concept.

19

REFERENCES

1. http://en.wikipedia.org/wiki/Finance

2. http://www.standardchartered.com.my/islamic-banking/personal-banking/personal-financing-i/en/

3. Garman & Forgue. 2010. Personal Financ.e USA: Joe Sabatino South-western

Cengage Learning. 10th edition.

4. zaharuddin.net

5. Nuradli Ridzwan Shah Mohd Dali et al. 2008. Introduction To Muamalat. Malaysia: McGraw-Hill (Malaysia).

6. M. Umer Chapra. 1985. Towards a Just Monetary System. Leicester, UK: The Islamic Foundation.

20