According to the American Journal of Islamic finance, more than 420,000 Muslim families in the USA don’t own a home; a relatively higher percentage than their non-Muslim peers. Islamic finance can bridge the gap between financing needs and homeownership.
Various Islamic financing products can be used for halal mortgages. IFIs not only facilitate the financing needs of the customer but earn an interest-free profit. IFIs refer to Islamic financial institutions that include all the Islamic banks and other Islamic finance institutions (OIFIs) offering Halal mortgage products.
How IFIs earn from Halal mortgage models?
The halal mortgage industry is improving its portfolio through customer-centric products. These products are not only in line with Islamic principles but also offer competitive profit rates with easy terms and conditions.
In this part of the article, you will learn about three different Islamic home loan products like Diminishing Mushrakha, Murabaha and Ijarha. You will also learn how IFIs earn from halal mortgage financing, and how it is different from conventional home financing?
Diminishing Mushrakha (DM)
Also known as Mushrakha Muntaqish: it is one of the most prevalent financing structures. Mushrakha Muntaqish or Diminishing Mushrakha is the joint ownership of a property between the customer and the bank.
Diminishing Mushrakha as a Halal mortgage financing
An elaborated explanation of DM is: In DM both customer and bank contribute with capital. The customer pays a portion of IFI’s share through regular installments. The customer also agrees to purchase a portion of the share in units. Gradually, it will reduce the ownership of the bank until the property is completely transferred to the customer.
The structure of DM is per sharia guidelines that are duly approved by Islamic scholars.
How do Islamic banks and OIFIs earn from Diminishing Mushrakha?
Suppose a customer wants to buy a property worth $500,000. At the initial stage, the customer will contribute 40% and bank will agree to add 60% to the capital. The rate of profit is 5% for 15 years of financing.
Below is the tentative monthly payment schedule under Diminishing Mushrakha Financing for one year.
|Balance Unit value
If you are not familiar with some terminologies like unit price and balance units then all those technical terms will be explained in the latter part of the article.
For the part of bank’s contribution, the customer will pay the monthly rentals and purchase the units. Both monthly rentals and the sale of the unit are the main sources of earnings for the bank.
The important part of this calculation is the profit rate. The profit rate covers all the operational, documentation, and legal charges born by the bank for purpose of Diminishing Mushrakha financing. The profit rate can be variable or fixed depending upon the agreement between the customer and bank.
Reconnecting with the above example and referring to the Diminishing Mushrakha repayment schedule, a 5% fixed profit rate will be used for the next 15 years of financing. The bank contribution in the purchase of property is 60% of the total value of the asset. That makes the bank’s contribution of $500,000*60%=$300,000.
Once you know the bank’s share, multiply it with the 5% profit rate. You will get the yearly amount of rentals. $300,000*.05= $15,000, 15,000 rent is for the year.
To calculate monthly, simply divide $15,000/12= $1,250. $1,250 is the rent for the first month and the income of the bank. For the subsequent months, the rentals will change according to the outstanding balance of the financing.
Sale of units
Now the second source of income is the sale of units. Units are the bank’s share in the property that customers promised to purchase every month.
There are two steps to calculate the cost per unit. First, you need to know the total number of units. Remember, 15 years is the financing period and customers need to purchase a unit every month. In a total of 15 years of financing, the customer will purchase 15*12=180 units.
Now you need to know the cost per unit. Remember, the bank’s share is $300,000. Now divide $300,000 with total number of unit 180, $300,000/180=$1,666. The customers need to purchase $1,666 units every month for the period of DM financing.
Difference between Diminishing Mushrakha and conventional mortgage
In conventional financing, the bank will receive interest and principal every month and no transfer of units. In the financing period if a customer can’t pay rentals the bank might foreclose the property. Other than losing the property, the customer might lose the paid installments too.
In Diminishing Mushrakha, if a customer gets defaults and does not pay monthly rentals, the Islamic bank will still recognize its ownership in the purchased shares. The Islamic bank can sell the property and will pass on the price of the ownership share to the customer. The bank is also entitled to recover outstanding rental payments in the period in which the customer has used the property.
In the USA, there are 25 Islamic finance institutions. Almost every Islamic finance house is offering Ijarha home financing. This broader adaptability is mainly due to its 100% Sharia-compliant features and hardly any difference of opinion found among religious scholars.
What is Ijarha home financing?
Ijarha is a lease financing for acquiring real estate assets. Under Ijarha, the bank (lessor) purchases the asset on behalf of the customer; contains ownership title and leases the property to the customer. The customer being a lessee can use the property as per agreed terms and pays consideration in the shape of monthly rentals.
How IFIs profit from Ijarha home financing?
Unlike Diminishing Mushrakha, there is no transfer of units to customers. The lessor is the owner of the property who receives monthly rental for the agreed lease period. However, at the end of the lease period, the lessor has two options:
- To sell the property after the lessee.
- Or to further lease the asset.
There is no capital contribution from a customer in Ijarha, Islamic bank will fully finance the asset. The bank earns from a monthly rental in Ijarha home financing
Now, let’s analyze the below example and learn what are the best possible options for banks to earn.
Suppose a customer wants to acquire a property that is worth $500,000. Upon request of the customer, the Islamic bank will buy that property and lease it to the customer. The agreed lease terms is for 15 years at profit rate of 5%. Below is the breakdown of Ijarha rental for one year.
The customer will pay a base lease of $3,953.37 every month and this is a source of earnings for the bank.
What is a base lease? As you can see from the above example, there are two-part to the base lease, one is the base rent and on account earnings. Base rent is also known as minimum rent that doesn’t account for other expenses like insurance and other documentation and evaluation expenses.
Base rent is obtained by the value of the property multiplied by the rate of rent. In the above case, the value of the property is $500,000 and the rate is 5%. Now, multiply $500,000 with .05 that makes $25,000, to calculate monthly rental for the first month divide $25,000/12=$2,083. For the next month, the base lease will change subject to the outstanding balance.
The other part of the base lease is the ‘on account’ expenses. There can be numerous types of expenses that are termed as on accounts like stamp duty on property, insurance (takaful), finance application fees and building inspection fees. All those expenses will add to the base lease and be borne by the customer.
From the sale of property
This approach in Ijarha is known as a financial lease. After payment of all the rentals, the client might want to purchase the same property. In that case, the bank will evaluate the prevailing value of the building in the market, also known as market value. After adjusting all the cost related to the property, the bank will sell the property and earns from the proceedings of that sale.
Difference between Ijraha and conventional lease
Tactically, there is one major difference between Islamic and conventional leases. The Islamic bank will only start taking rentals when the customer has started to use the property whereas, in a conventional bank, the bank will start taking rentals as soon as the contract commences.
It is a sale contract, where an Islamic bank purchases the asset at the request of the customer. At the time of sale, the Islamic bank will disclose incurred cost plus profit. The customer will promise to pay cost plus profit in a lump sum or installments.
The legality of fixing the cost and the profit price in Murabaha is permissible in the testimony of hadith from Ibn Masud(RA) and Al-Kasani in his book Al-Badai wa al-Sanai that people inherited these transactions or sales.
How Islamic bank earns from Murabaha home financing?
Once a customer purchases the property, he is required to repay in monthly, quarterly or semi-annual installments. The mode of repayment can be agreed upon between the parties, there is no obligation to pay monthly, as you have observed in the case of Ijarha and DM.
Moreover, in case of default or delay of installment, an Islamic bank can impose a penalty, a smaller or the bigger part as per the agreement can be awarded to the institution.
Difference between Islamic Murabaha and conventional loan
Islamic banks are striving to offer a market competitive rate to their customers. However, in some cases, the Murabaha financing can be more expensive than the conventional home loan. There are a couple of reasons behind this analogy:
- When an Islamic bank is the buyer of the building or land, the bank has to hire services for property evaluation. That results in an increased operational cost that overburdens the total cost of Murabaha financing.
- Until the customers will not purchase the property, the risk of the asset will remains with the Islamic bank. Islamic banks have to bear expenses like insurance and safekeeping.
Top Five Islamic finance institutions for Halal mortgage in the USA
According to the Islamic finance development report 2021, North America is among the top-7 performing regions in the world in terms of Other Islamic finance institutions’ assets growth. The prominent countries in North America regions are the USA and Canada where OIFIs are offering different home financing facilities to their customers.
In the USA, there are top five Islamic finance institutions for halal mortgage financing that includes:
- UIF corporation
- Guidance residential
- Devon Bank
- Ijara CDC
It’s definite to say, halal mortgages play a pivotal role in the growth and productivity of Islamic financial institutions. Especially Islamic financing products like Diminishing Mushrakha, Ijarha and Murabha facilitating major retail banking services.
Now, let’s discuss briefly the similarities and differences between Islamic and conventional home financing:
|Ijarha & conventional lease
|The rate of rental is determined on basis of market forces.Both conventional and Islamic offer almost the same interest and profit rates.
|The Islamic bank will start taking rentals when the asset is delivered, whereas a conventional bank will start earning as soon the contract starts
|Mushrakha and conventional house financing contract
|In Both conventional and Islamic, the bank will not share in the loss; the client will bear all the losses.
DM allows ownership of units after periodic payment of rent and purchase of units. Whereas, in a conventional loan, the ownership is transferred after completion of installments.
|Murabaha and Conventional house loan
|Both Islamic and conventional lend money for the purchase of a property.
|In a Halal mortgage, the client becomes the owner of the property but at the same time liable to pay the full priceWhereas in a conventional loan, the ownership is transferred after payment of full installments.