ISLAMIC BANKING: MORTGAGES

Riba free Mortgages

Introduction

The three common forms of Islamic contract for house purchase finance are Murabaha, Ijara and Musharaka. In the first arrangement, the bank buys and sells it back to a client at a higher price, which is repaired in instalments. In Ijara, the bank buys the property and rents it out to the purchaser, who makes payment which covers purchase of the equity by instalments and rent for the use of the amount of equity still owned by the bank. Diminishing Musharaka is also a popular mode of mortgage financing for Islamic banks in a number of countries. The earliest Islamic mortgages preferred in Britain were Murabaha arrangements, but Ijara seems to be now preferred (Elaine Housby, Islamic House Purchase Loans in Britain, ISIM Review 17, Spring 2006, p. 28).

Murabaha has been criticized by some Shari’ah scholars “for being no more than a device to disguise the charging of what is in effect fixed interest, but it seems also to be due to the fact that is easier for the bank to vary repayments under an ijara contract” (ibid). The Council of Mortgage Lenders in Britain in a fatwa ruling of 2001 allowed payments in an Ijara mode of financing to correspond with the variation in the rate of interest under a conventional mortgage (Council of Mortgage Lenders, Islamic Home Finance, 2001). Financial institutions in the United States offer all the three modes of mortgage financing, i.e. Murabaha, Ijara and Musharaka.

“The Musharaka is a legally binding contract to form a partnership to buy the property. That agreement allows the home buyer exclusive use of the whole property and extracts a morally binding promise from the buyer to purchase the property from the investor in the future”.

Diminishing Musharaka refers to a partnership established under a contract by the mutual consent of the parties for joint ownership of the property. It allows equity-type participation for the bank which then rents out its share of the property to the client who eventually becomes the sole owner after full payment is made. The term “Musharaka” is derived from fiqh concept of “shirkah” which means sharing or partnership. There are two types of Musharaka preferred by Islamic financial institutions:

Shirkat-ul-Milk – Joint ownership between two or more persons or parties in a particular property or asset that may not necessarily be for earning profit.

Shirkat-ul-Aqd – A contract between two or more persons or parties participating for a common business objective the sole purpose being to share profits and losses arising from the enterprise in accordance with the principles of Shari’ah.

Where regulatory regulations do not permit banks to own property for investment purposes, the asset is registered in the name of the client. However, Islamic Shari’ah law requires that there be joint ownership for which the bank signs a legally binding (joint ownership) agreement with the client. In order to protect the bank’s ownership in the property, the client has to create a mortgage on the property in favour of the Islamic Bank.

Late Payment

Islamic Shari’ah does not allow penalties to be charged as part of the bank’ profit and loss (P&L). However, the client has to pay a certain amount to the bank’s zakat charity fund as per the Musharakah agreement signed.

Subject to Shari’ah Advisory Board approval, the bank is permitted to charge the client a certain amount to cover its administrative costs relating to late payment recovery process.

Equity Investment Risk

The Bank, in mortgage financing, is not exposed to any price devaluation risk. The client is liable to buy out the bank’s investment at the pre-agreed price and as per an agreed schedule.

The Loan to Value is maximum percentage (i.e. 85%) of the property value which addresses price fluctuations.

In the event of a client defaulting, bank will issue a notice of termination to the former upon which they would have to buy out the face value of the bank’s share of the property pursuant to the Purchase Agreement.

This liability would become a conventional debt and claimed as such.

It is mandatory requirement that the client obtains property and life insurance/takaful cover.

The bank must have adequate systems and controls in place, including global Shari’ah Advisory Board as well as a local Shari’ah advisor for day to day advisory, to ensure compliance with Shari’ah rules and principles. The Shari’ah advisor is required to periodically audit any product/portfolio.

The Islamic Bank is required to undergo a Shari’ah compliance review by Shari’ah Advisory Board or external auditors with required knowledge and expertise in Islamic banking at least once annually.