What is Islamic finance? We explain what it is and why to consider an Islamic bank for a savings account

If you’re keeping an eye on the rates being paid by the best savings accounts, now could be a good time to consider an Islamic bank. We explain how they work.

Islamic finance follows the principles of Islam and the teachings of the Koran, but it’s available to anyone regardless of religion. 

Islamic banking, also called Sharia banking, has become increasingly popular as some of the core principles include not benefitting from practices like gambling and sharing profit and risk between banks and customers. In this respect there’s common ground with ethical finance.

There’s one big difference in Islamic banking for savers: you can’t earn interest from cash deposits in the traditional banking way. Instead, the money you earn on savings is from the profit the bank makes by investing your money in certain projects and is known as the ‘expected profit rate’ (EPR).

In 2022 Islamic banks like Al Rayan, Habib Bank AG Zurich, Gatehouse and the Bank of London and the Middle East have regularly topped our savings rates tables ahead of the paltry interest rates offered by high street banks.

We explain what you need to know about Islamic finance.

Islamic finance versus conventional finance

Islamic finance, also called Sharia banking, is banking that adheres to Islamic law. Some of the core principles include the following:

• Not charging interest to borrow money, including mortgage borrowing
• Not paying interest on savings or current accounts
• Not benefitting from investing in businesses involving armaments, gambling, pornography, drugs, tobacco, pork or alcohol 
• Not entering into high-risk investments
• Sharing profit and risk between banks and consumers

This is different from conventional banks where there are no such restrictions. Conventional banks also treat money as a commodity and lend it to their customers in return for interest as a means of compensation. 

Islamic banks are not money-lending organisations but operate as a trading or investment house with money being invested in a way that all parties share the risk and profit. 

Islamic finance products are usually asset-backed and involve trading of assets and renting of assets. Popular investments include financing property and construction schemes.

What is an expected profit rate and how does it differ from interest?

The key difference if you choose a Sharia bank for your savings is the way the return on your cash deposit will be presented. 

Under Islamic law money itself has no intrinsic value - it is simply a medium of exchange. This means earning interest is not allowed.

Instead, money is invested, in return for an 'expected profit rate'. Essentially, you enter into a joint investment venture or profit share type of arrangement with the bank.

In practice you hand over your savings to the bank to invest with the expectation of getting back a certain percentage profit.

This doesn’t sound any different to conventional saving with a traditional bank, does it?

However, the ‘expected profit rate’ is not guaranteed. It does not usually happen - it has yet to happen with a Sharia bank in the UK - but Islamic finance means accepting the bank may not provide it.

Gatehouse bank, for example, says on its website: “If we believe the expected profit rate will not be achieved, we will contact you giving you notice of the new expected profit rate.”

Al Rayan says: “The expected profit rate that applies to your savings account is variable. This means that it can change at any time.”

In reality savers should feel confident that what Islamic banks say is indeed what they will get. Sharia-compliant banks have a reserve fund specifically to cover times when they run at a loss. 

On top of that their business model depends on savers’ cash as they cannot borrow from the interbank market, the system in which banks lend funds to one another for a set term.

Islamic finance and FSCS protection

Sharia-compliant bank accounts are protected in exactly the same way as savings accounts offered by other regulated banks in the UK.

This means you have FSCS protection on deposits up to £85,000 per person, per banking group in case something goes wrong with your bank.

Interested in applying your personal principles to your finances? Read how the Mack family changed their current accounts after learning banks finance climate change.