How Islamic savings accounts work

Islamic savings accounts are designed to offer the estimated 2.9 million Muslims living in the UK a way of saving that's compliant with Sharia (Islamic religious law). Such accounts are open to non-Muslims as well and sometimes can be the highest paying option for all savers, regardless of their religious beliefs.

A quick look at the best-buy tables for fixed-rate savings accounts shows several Islamic banks are leading the way. Al Rayan Bank tops the table for 18-month bonds with a rate of 1.71% and two-year bonds with a rate of 2.02%. The highest fixed-rate account on the market is from another Islamic bank, the Bank of London and the Middle East (BLME). It pays 2.5% if you're willing to tie up your cash for seven years. Other banks offering Sharia-compliant savings accounts to UK customers include Milestone Savings and United National Bank (the latter also offers conventional savings accounts).

One key difference between conventional savings accounts and Sharia-compliant ones is that Sharia accounts don't technically pay interest. That's because lending money to earn interest is forbidden in Islam, as Muslims believe it promotes unfairness and leads to social inequality and injustice. Hence Sharia-compliant savings accounts pay savers an "expected profit rate" instead. This comes out of the profit the bank earns from investing the money. Such investments may include Islamic mortgages, which are also designed in such a way that no interest is paid essentially, the bank buys the house and sells it to their customer in instalments.

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Consequently, the return on an Islamic savings account is not guaranteed and savers may not earn the return they expect if the bank's investments do not perform well. Still, "although there is an inherent risk involved, Islamic providers are keen to state that expected profit rates are usually achieved and we're unaware of any instances where this has not happened", says Tom Adams of Savings Champion, which tracks rates on Sharia-compliant savings accounts.

"In addition, most providers will allow you to take funds away before the end of the term if the expected profit rate is not likely to be met." Al Rayan Bank, for example, says that "it has always paid the rate of profit it has quoted to its customers, and on numerous occasions, when investments have performed better than expected, it has even paid more".

Under Sharia principles, if the bank's investments make a loss, depositors' capital should share in the loss, which would make Islamic accounts far riskier than traditional savings accounts. However, allowing capital to be at risk in a savings deposit breaches UK banking regulations, so UK-regulated Islamic banks would be obliged to offer to make good your loss. Account-holders are then free to accept this or to reject it if they feel that doing so would go against their religious principles.

Importantly, UK-regulated Islamic banks are covered by the Financial Service Compensation Scheme (FSCS), which protects up to £85,000 per person, per banking licence in the event the bank cannot meet its obligations. As with conventional accounts, amounts in excess of this could be at risk, so if you have a large balance, spread it between different banks to maximise your protection.

So there are differences between Sharia-compliant accounts and conventional accounts. However, in practical terms, accounts offered by UK-regulated Islamic banks should function similarly (although there is always the possibility the expected profit rate won't be achieved).

This includes tax treatment profit from Islamic accounts would count towards the personal savings allowance, just like conventional interest. So savers looking for a table-topping rate may want to consider these deals. But as ever, check terms and conditions carefully, including how long your money would be locked up with fixed-rate accounts and whether you could access it early.