INVESTMENT in a home typically represents the single largest investment most individuals will ever make. Home equity on average represents up to 40% of consumer equity in developed markets around the globe. A well-functioning home finance market offers incentives for households to save, provides investors with opportunities to gain stable, longterm returns, creates large numbers of jobs for skilled and unskilled workers in construction and ancillary industries, enables homeowners to leverage their physical assets into financial assets for investment, and contributes greatly to the deepening and broadening of the financial sector. Housing market activity is thus an important leading indicator of overall macroeconomic activity and has a tremendous impact, both in terms of providing social stability and in promoting economic development. Accordingly, ensuring the availability of housing and the growth of housing Finance markets is a policy priority in most countries.
Unfortunately, this facilitation has always occurred on a conventional interest-based platform, hence limiting its benefit to Muslims, in particular those living in Western countries. With the recent availability and rapid proliferation of Islamic mortgages however, the benefits of Islamic financing can now be brought to not only the interest-averse, but the traditionally non-Shari’a compliant as well.
As with the overall financial paradigm of which it is a part, an Islamic mortgage is based on the ownership or transfer of ownership of an asset, in this case the property, and follows a certain defined process with adherence to specific Shari’a requirements. A conventional mortgage on the other hand is in essence just a loan of money upon which interest is charged.
What follows is a basic illustration of what Islamic mortgages are all about with a particular focus on home purchasing. As a basic overview, this will hopefully provide readers with the essential knowledge required to investigate further, and in the case of genuine home buyers, help make some educated decisions regarding what is available in their markets. Obtaining financing from an institution logically dictates that one be eligible to do so. Similar to any credit facility, a financier would need assurance that the applicant is capable of entering into such a business transaction and would have the ability to maintain his or her responsibilities throughout the contract.
A mortgage is essentially an asset-based securitized program, and can be seen as less risky than, for example, conventional unsecured finance (personal loans, credit cards) but even then an individual’s credit worthiness plays a vital role. Most institutions will initially assess an application on three main criteria before any decision to proceed is made.
“Credit” is the picture an applicant presents in terms of payment worthiness. Credit history in most markets is transparent and readily available information from standard credit bureaus and provides a clear insight into whether the applicant makes payments on time or not.
“Capacity” refers to the applicant’s ability to meet the financial obligations present in a housing business contract, namely the initial equity, the monthly installments, as well as a number of additional costs pertaining to property and documentation. Monthly income is assessed (whether through an official salary certificate or through a certified income estimation agency), and the existing debt burden is determined. The new post-home financing debt burden is normally capped at 50% of gross monthly income.
“Collateral” is the current market value of the property. Most financiers (adhering to local regulatory requirements) cannot finance more than a defined portion of the value, for example 80%. This allows for a protective leeway in the event that the property depreciates in value. Formal property appraisal through an independent agency is the norm. Related to this is the correctness of property documentation and present owner status, in terms of adherence to municipality construction by-laws, encumbered titles, and other factors.
Literally, Murabaha means a “profitable sale” and is also called bay’ al-mu’ajjal, meaning deferred payment sale. This is essentially an installment sales contract for real property. Of the various Shari’a-compliant approaches this is the method that is nearest in appearance to a conventional program. It involves, as expected, a fair amount of capital up-front. The home buyer’s equity is usually set at a minimum of 20% of the overall purchase price. Upon purchase, the property will be registered in the individual buyer’s name and is followed by a fixed repayment period that is serviced by a set installment (usually monthly) that is agreed between the buyer and the financier. Both the sale price and the agreed upon cost plus profit price are completely disclosed at the time of signing the contract, and remain fixed for the entire period. The buyer also has the liberty of making an early payment on the property at any point.
In essence this option involves the home buyer arranging a sale price with a seller as normal, however with the financier or bank paying this purchase price, and then immediately selling the house to the buyer at a higher price.
A murabaha-based option would involve a financier or “Bank” and the buyer or “Client” as follows:
1. The Client informs the Bank about a financing need and the particular property to be purchased.
2. After an approval process (involving individual credit eligibility assessment as well as property appraisal) the Bank enters into an overall murabaha agreement with the Client, according to which the Client undertakes to buy the house from the Bank.
3. The Bank then purchases the house either by itself or appoints the thentas its agent for the purchase on its behalf.
4. After taking possession of the house (along with its risks and obligations) the Bank then sells the house to the Client and fixes a selling price after adding its profit to the transaction. The profit is based on the tenure of sale, Client creditworthiness and initial downpayment size.
5. An installment payment schedule is provided to the Client along with the agreement after the sale and the title of the assets are transferred to the Client (with all its risk and obligations).
6. In the case of late payment a charge may be levied for willful defaults but this cannot be taken into Bank income (with such a charge normally going to a designated charity).
There are however some issues which traditional service providers have to face. First, the mode has a certain perception problem relating essentially to its similarity to a conventional loan, even though it is fully Shari’a-complianL Second, banks may be unwilling to enter into a murabaha transaction for a longer-term tenure (over 10 years) due to the fixed rate of return. Lastly, the murabaha may not be rolled over.
THE IJARA MORTGAGE
Another mode is called Ijara. The essential meaning is “letting on leasing”. This is a slightly more common choice of mortgage, as it is somewhat more flexible than its murabaha counterpart. As with the murabaha mortgage, a buyer selects a property and agrees on a purchase price with the seller. The difference is that the financier then purchases and gains ownership of the property. The buyer enters into a lease agreement and is expected to pay rent to the financier as a contribution towards the purchase of the property.
An ijara structure engages the “Bank” and “Client” as follows:
1. The Client informs the Bank about a financing need and the particular property to be purchased.
2. After an approval process (involving individual credit eligibility assessment as well as property appraisal) the Bank purchases the property and leases it out to the Client through an ijara agreement for a specified period, and thereby becomes entitled to receive rentals from the date on which the Client starts to use or occupy the property.
3. The house remains in the ownership of the Bank throughout the lease period and the Bank covers this risk by Takaful (Islamic Insurance) if available. If takaful is unavailable, some scholars have allowed the use of basic conventional insurance on the basis of need.
4. The monthly rentals are based on the security deposit, tenure of lease and the Bank’s investment and rate of return targets.
5. The Bank also offers to sell the property at a given price after completion of the lease tenure.
6. The Client can purchase the house at any time during the tenure of the lease after making an offer to the Bank. A proper offer and acceptance is required to execute the sale.
7. For ownership, security and guarantee reasons the house documents are held with the Bank until the end of the transaction.
8. In the case of late payment of rentals a charge may be levied but this cannot be taken into the Bank’s income (with such a charge normally going to a designated charity).
Ijara provides the flexibility of early payments and the rentals may be changed based on mutual consent However, prevalent laws and regulations exist that mosUy favor the tenants of a house and therefore service providers may be wary of possible default Also, it is important that the leasing and selling contracts are transacted separately and not linked to one another.
DIMINISHING MUSHARAKA MORTGAGE
Musharaka is derived from the Arabic Sharika and may include the joint ownership of two or more persons in a particular asset including property. It is this mode that the diminishing musharaka, also known as a declining balance partnership, is based on. In this structure, the client purchases a predetermined share of the property through an equity contribution while the remainder is owned by the financier. The client’s total monthly payment is a combination of continuing equity injection and an agreed upon rental payment for the right to use the financier’s share. Naturally then, as the financier’s equity is decreasing over time, this rental payment proportionally decreases.
Under this mode of financing, the financier and the buyer jointly purchase a property. The ownership is then divided into equal musharaka units and each party owns units commensurate with their investment share.
A diminishing musharakah structure entails the following for the “Client” and “Bank”:
1. The Client informs the Bank about a financing need and the particular property to be purchased.
2. After an approval process (involving individual credit eligibility assessment as well as property appraisal) the Bank enters into an overall agreement with the Client, according to which the Client undertakes to buy the Bank’s share of the property that both parties have agreed to purchase at an agreed price.
3. The Bank and the Customer then jointly purchase the property. This can either be purchased by the Bank or by the Client, but it will be a joint ownership through a musharaka agreement, and both parties share the risk and obligations related to the property.
4. The ownership of the property is divided into equal units which are owned by the Bank and the Client commensurate with their respective shares.
5. The Bank and the Client then enter into a rental agreement whereby the Bank rents out its share in the property to the Client.
6. An option is usually given to the Client to buy the Bank’s units at a certain price on a particular date.
7. The Client purchases units from time to time (usually monthly) from the Bank and each time a proper offer and acceptance is required to execute the sale. Accordingly, the utilization payments to the Bank reduce and in the end the entire ownership of the house transfers to the Client.
8. In the case of late payment of rentals a charge may be levied but this cannot be taken into the Bank’s income (with such a charge normally going to a designated charity).
9. For security and guarantee reasons the house documents are held with the Bank until the end of the transaction.
10. In case the Client desires to buy the property earlier, this can be done by making an offer to the Bank for its remaining share in the property’s equity.
This mode gives the flexibility to the client to buy units earlier, and thereby lower monthly installments, and generally works well for medium to long-term agreements. However, care needs to be taken to ensure that the leasing and selling contracts are conducted separately and are not linked to one another.
Most providers benchmark their pricing to conventional interest rates in their market This initially appears controversial to some, but it must be realized that the Shari’a does not forbid using benchmarks as standards of measurement It is the underlying structure of the contract not the tools of measurement, that determine permissibility. And while it may be more ideal (though still not obligatory) to rely on purely Islamic modes of measurement, the general absence of comparable benchmarks necessitates this modern expethent An external benchmark is used to competitively price the product, protecting both the financier in terms of meeting required cost and profitability targets, as well as the buyer in terms of transparency and ensuring that Shari’a-compliant instruments are not unnecessarily expensive.
As the Islamic home finance market matures into an increasingly viable source of property financing, some challenges still remain. The additional expense in some countries caused by the double-charge of stamp duty is one example: first charged to the financier and then charged once again to the ultimate buyer upon transfer. Insurance is also a significant concern, as takaful is still not widely available.
Those Muslims seeking a Shari’a-compliant alternative to interest-based financing finally have a number of choices that were largely theoretical until only very recently. And while Islamic home financiers still require home buyers to sometimes pay a small premium for a structure that necessitates a higher cost, the phenomenal growth of the market ensures that customers should continue to expect not only increased product sophistication, but also more value from their Islamic home finance retailers.