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Broker Guides

A broker’s guide to Islamic finance

Tom Belger | 11:58 Monday 1st May 2017

Sharia-compliant products are available to UK homebuyers, but unlike standard deals they don’t charge interest. Here’s a guide to taking out a mortgage.

Central to Islamic finance is the fact that money itself has no intrinsic value; it is simply a medium of exchange. Each unit is 100 per cent equal in value to another unit of the same denomination and you are not allowed to make a profit by exchanging cash with another person. A Muslim is not allowed to benefit from lending money or receiving money from someone.

This means that earning interest (riba) is not allowed – whether you are an individual or a bank. To comply with these rules, interest is not charged on Islamic mortgages or paid on Islamic savings or current accounts.


Taking out a mortgage

Islamic mortgages, or house purchase plans (HPPs) can involve ijara, where you are technically leasing the property from the bank, or diminishing musharaka, where you buy in partnership with the bank and your monthly repayments gradually buy it out.

As with a standard mortgage you will usually need a deposit, and you will need to have the house valued before you enter into the arrangement. Some banks also offer a buy-to-let house purchase plan.

In an Islamic mortgage transaction, instead of lending the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in instalments.


Sharia-complaint finance

These principles of Islamic finance mean that methods to undertake transactions differ from conventional finance. Common sharia-compliant instruments include:

Ijara works as a leasing arrangement: the bank buys an asset for a customer and then leases it back to them. Different forms of leasing are permissible, including those where part of the instalment payment goes toward the final purchase. This might be used to help you buy a car or other item, or to help a business buy equipment.

Murabaha works by the bank supplying assets for resale to the customer at a price that includes an agreed mark-up. It is agreed by both parties, and the agreement allows them to repay in instalments. This might be used to provide a mortgage on a property. The property is registered to the buyer from the start.

The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a property, with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled.

Musharaka is a joint venture in which the customer and bank contribute funding to an investment or purchase and agree to share the returns (as well as the risks) in proportions agreed in advance.

This innovative approach for home loans allows for a floating rate in the form of rental.

The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank’s share of the property at agreed instalments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party’s current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate).


How do the banks make money?

Although they cannot charge interest, the banks can profit from helping customers to purchase a property using an ijara or murabaha scheme. With an ijara scheme the bank makes money by charging the customer rent; with a murabaha scheme, a price is agreed at the outset which is more than the market value. This profit is deemed to be a reward for the risk that is assumed by the bank.

Strict due diligence is needed to assess the viability of a business proposal before funding is agreed and any proposed venture must be certified by an expert (Scholar) of Islamic law.

There are firm laws governing the types of businesses with which the banks can trade. Certain ones deemed non-ethical or incompatible with Sharia law (Haram) are forbidden and include those involved with conventional financial services, pork, tobacco, gambling, drugs, alcohol, weapons, or pornography.

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