THEORY RIBA: CONVENTIONAL PERSONAL FINANCING VS ISLAMIC PERSONAL FINANCING

THEORY OF RIBA Definition

CONVENTIONAL PERSNAL FINANCING

ISLAMIC PERSONAL FINANCING

Types and Classificatio n Stages of Revelation from alQuran Prohibitio n from Hadith

Theory

Theory

Money Management Investmen ts Insurance Retiremen t Planning

Bai `Inah

Tawarruq

Al-Ijarah Murabaha h

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 Quran. 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.

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 Ala 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-Nasiah is where the specified increase is in return for postponement of the payment. The term Nasiah 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-Nasiah and Riba al-Fadl are both covered by the verse, Allah has allowed trade and prohibited riba (2:275), while Riba-al Nasiah relates to 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 mens 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).

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.

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 persons 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 expenses and
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http://en.wikipedia.org/wiki/Finance Garman & Forgue. 2010 Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10th edition.

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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 noninstallment 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 require monthly payments of RM105 for 60 months at seven percent interest. Non-installment credit
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Garman & Forgue. 2010 Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10th edition. Garman & Forgue. 2010. Personal Finance. USA: Joe Sabatino South-western Cengage Learning. 10 th edition.

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

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

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INVESTORS

MUTUAL FUND (INVESTMENT COMPANY)

A DIVERSIFIED PORTFOLIO OF SECURITIES

Purchase shares in Purchase shares in

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 finance. This is to make sure that the person would not make a wrong decision regarding financial affairs in his life.

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

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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.

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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 publics 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, lets 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:

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

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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:

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http://en.wikipedia.org/wiki/Islamic_banking http://azamlaw.com/index.php?p=article001

12

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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.

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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 deferredpayment basis and the price is payable in installments. It can be applied for all things except ribawi items like gold and silver. In addition, the sale contract must be separated. The flow of transaction as follow:
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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 SyafiIs 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.

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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:

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NO.

CONVENTIONAL PERSONAL FINANCING

NO.

ISLAMIC PERSONAL FINANCING Islamic Personal Financing based on the Islamic perspective No provision to charge any extra money from the defaulters. Islamic promotes personal risk financing, sharing it

1.

Conventional Personal Financing based 1. on fully manmade principles

2.

It can be charge additional money called 3. riba (penalty and compounded interest) in case of defaulters In conventional personal financing, the 4. investor is assured of predetermined rate of interest

4.

between

provider of capital and the user of funds. It also aims at maximizing profit but subject to shari`ah restrictions For the Islamic Personal Financing, it must be based on a shari`ah approved underlying transaction Islamic personal financing can give guarantee deposits for deposit account based on the principles in Islamic perspectives The status

5.

It aims at maximizing profit without any 5. restriction

6.

For interest-based conventional personal 6. financing, borrowing from the money market is relatively easier. A conventional personal financing has to 7. guarantee all its deposits.

7.

8.

The status of a conventional personal 8. financing in relation to its clients is that of creditor and debtors.

of

Islamic

personal

financing in relation to its clients is that of partners, investors and trader, buyer and seller. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.

In conventional personal financing, it is 9 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. Lending money and getting it back with 10. compounding interest is the essential function of the conventional personal

10.

Participation in partnership business is the fundamental function of the Islamic personal financing. To get rid of any unjustified or exploitative financial situation, product or service, not just in a 18 loan transaction but in any bits that are unfair or exploitative in the financial world.

11.

financing In conventional personal financing, it not 11. concerned about unfair or exploitative in the financial world

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 baiinah. 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. Baiinah 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.

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REFERENCES
1. http://en.wikipedia.org/wiki/Finance 2. http://www.standardchartered.com.my/islamic-banking/personal-banking/personalfinancing-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.

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