Differences Between Sharia and Conventional Financing, Which One to Choose?

In the financial world, the choice between Islamic, or sharia, and conventional financing is often an engaging topic of discussion. Both offer financial solutions, but with different principles and mechanisms. Understanding the differences between the two can help you make a more informed decision when choosing the financing method that aligns with your needs and values. Therefore, let’s delve deeper into the distinctions between Islamic and conventional financing and examine each difference one by one.

Understanding Sharia Financing

Islamic or sharia financing is a type of financing based on Islamic Sharia principles. In this form of financing, all transactions must comply with Sharia law, which prohibits activities that are forbidden in the Qur'an and Hadith. One of the main principles in Islamic financing is the prohibition of riba or interest. Islamic financing also forbids speculation and any transactions involving uncertainty, known as gharar.

Understanding Conventional Financing

On the other hand, conventional financing operates based on the legal and regulatory framework generally applied in the banking world. This type of financing uses interest as compensation for loans provided to customers. The interest system is a key characteristic of conventional financing.

Differences Between Sharia and Conventional Financing

The differences between sharia and conventional financing institutions are fundamentally significant, in terms of basic principles, product mechanisms, risks, and penalty mechanisms. Understanding these differences is crucial for those who wish to choose the financing method that best suits their needs and values. Here are six key differences:

1. Basic Principles

The distinction between Islamic and conventional financing can be observed in their basic principles. Islamic financing is based on Sharia principles that emphasize justice, transparency, and social welfare. One of its main principles is the prohibition of riba, which, in the context of financing, means the prohibition of charging or paying interest.

In contrast, conventional financing operates on the principle of profit generation through interest. This system does not require a real transaction or detailed contract as long as both parties agree to the terms. This is one of the main differences between Islamic and conventional loans.

2. Products and Contracts

In Islamic financing, several types of contracts are used depending on the type of transaction and customer needs:

• Murabahah: This is a sales contract where the bank purchases goods needed by the customer and resells them to the customer at a profit margin agreed upon.

• Ijarah: Similar to leasing in conventional financing, but without interest. In ijarah, the bank leases goods or assets to the customer for a specific period with agreed compensation.

• Musyarakah: In this contract, the bank and the customer participate in business capital and share profits or losses based on their respective contributions.

• Mudharabah: This involves a partnership between the capital provider (the bank) and the business manager (the customer). The bank provides capital, while the customer manages the business. Profits are shared according to an agreement, while losses are borne entirely by the capital provider unless caused by the manager's negligence.

Conversely, conventional financing offers more diverse and flexible products, most of which are based on the interest concept. Common products include:

• Interest-Based Loans: The most basic form of conventional financing, where the bank provides loans to customers with interest to be paid over a specified period.

• Leasing: A rental system similar to ijarah, but using interest as compensation. The customer rents assets from the bank and has the option to purchase the asset at the end of the lease term.

• Mortgage: A loan secured by real estate collateral. The customer receives a loan with property as collateral, and interest is paid over a certain period. If the customer fails to pay, the bank has the right to seize the property.

3. Penalties

The approach to penalties in Islamic financing is very different from conventional financing. In Islamic financing, penalties are applied as compensation for losses caused by late payments but cannot be a source of profit for the bank.

The penalties imposed are usually directed toward social or charitable activities, in accordance with Sharia principles that emphasize justice and welfare. This is intended to prevent the bank from profiting from the customer’s difficulties and to encourage timely payments.

In conventional financing, late payment penalties are often used as an additional source of income for the bank. These penalties are calculated as a percentage of the unpaid loan amount, which can increase the financial burden on the customer.

4. Regulation and Compliance

In Indonesia, Islamic financing is supervised by the National Sharia Board (Dewan Syariah Nasional) and the Financial Services Authority (Otoritas Jasa Keuangan) to ensure that the products offered by Islamic banks comply with Sharia principles. DSN is responsible for issuing fatwas and guidelines that Islamic banks must follow, while OJK oversees the implementation of these regulations in daily practice.

Conversely, conventional financing is regulated by the Financial Services Authority (OJK) based on general banking regulations. The OJK oversees all banks and financial institutions to ensure compliance with applicable laws and regulations, including those related to interest rates, consumer protection, and financial stability.

Although the OJK also oversees Islamic banks, the regulations applied to conventional financing differ in several aspects, particularly those related to the use of interest and penalties.

In conclusion, the explanation of the differences between Islamic and conventional financing highlights that choosing between the two depends on your needs, values, and preferences. Islamic financing offers a more just and transparent approach with risk and profit-sharing, as well as adherence to Sharia principles.

Conversely, conventional financing offers flexibility and convenience with fixed interest rates, but more risk is borne by the customer. Whatever your choice, it is important to fully understand the mechanisms, risks, and consequences of each type of financing.

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