Islamic Home Financing: Is It Really Halal?

Islamic home financing is quite popular nowadays. Before we go any further, let’s talk about whether mortgage loans are permissible in Islam. In general, Islamic scholars agree that a mortgage loan with interest payments is not permissible. Some scholars have stated that if it is unavoidable, extenuating circumstances may make it permissible. However, it is now possible to avoid taking out an interest-bearing mortgage when purchasing a home. Nowadays we have options to choose the mortgage with a shariah-compliant approach. In the following, you can read more about Islamic home financing.

Understanding Islamic Home Financing: Lease to Own Structure

Islamic home financing is available in Islamic consumer banking. The most common form of home financing is a lease to own. It is popular in the Middle East and in Asia, Europe, and the United States. In this scenario, the bank purchases the property and leases it to the consumer for a set length of time. At the end of the period, the bank will transfer the homeownership to the customer. The bank (or the investors, if the property was part of a securitization) owns the property throughout the lease period, and the payments paid to the bank are rent plus profit (of the bank) to buy out the house from the bank over time. The bank is the sole owner of the property during the lease term, and the client is a renter with rights to the property and a stake in it should he decide to buy it.

Like traditional home finance, any customer bears the rise or decrease in the property’s value. The lease terms are stated upfront so that the customer has a clear comprehension of the structure as well as the terms under which their equity is invested.

Partnership Financing Structure

This structure is one of the most common ones among home buyers. Under a partnership financing structure, the bank and the person who buys the home are partners in the property purchase. This is an all-equity transaction and without using any debt. The home buyer’s down payment is their equity stake in the venture, and the bank’s financing is their equity stake. For instance, if the home price is $300,000, the purchaser puts down 10 percent, or $30,000; the bank would “invest” $380,000 and own 90 percent of the home, with the financing period of 30 years.

The home buyer will pay the bank rent plus profit overtime to buy out the bank’s equity stake in the property. So, over 30 years, the bank’s property ownership would gradually decrease from 90% to zero, leaving the home buyer as the only owner. Because one partner’s portion of the profits declines over time, this is also known as a declining partnership arrangement. In some jurisdictions, this scheme is also called Musharakah Mutanaqisah (diminishing partnership)

The attractiveness of this structure is that the partners share any growth or decrease in the property’s value based on their respective percentages of ownership. If the property’s value drops, both parties lose money based on their ownership stake. In this case, the parties cannot lose more than they invested in the property.

The Price of Islamic Home Financing

The first thing you should know is that an “Islamic mortgage” is not, in fact, a mortgage. It is a completely new financing model based on the concepts of partnership and co-ownership. While the structure is not the same as a traditional mortgage, the costs are comparable.

Down payment

The down payment is usually the most important expense on a buyer’s mind. The cost of a down payment will vary depending on a number of factors, the most important of which are the price of the home and your ability to spend. You will be able to get a lower rate on your monthly payments if you can afford a down payment of at least 20% of the buying price of your property. Islamic Finance, on the other hand, has systems in place to offer halal Islamic home financing with as low as a 3% down payment.

Closing Costs

However, the down payment is not the only upfront cost. You should also take losing costs into account. Additional fees such as lawyer’s fees, escrow charges, appraisal fees, finance fees, and utility adjustments are within closing expenses. Closing costs should cover 2% of the purchase price as a rule of thumb. To fund both the down payment and closing fees on a $200,000 home with a 5% down payment, then you’d need $14,000.

Monthly Payments

The monthly payments are what remain after the initial down payment and closing charges have been paid. While the payments are structured up to look like mortgage payments, the foundation is quite different.

You are a co-owner of the property rather than a borrower when you finance a home with an Islamic Finance mortgage. This implies you won’t be repaying a loan with interest; instead, you’ll be purchasing a larger share of co-owned property. To put it another way, your monthly payments are a way for you to progressively purchase co-owner’s portion of the property.

As an example, suppose you choose a $100,000 house and pay 5% (or $5,000) of the purchase price, with an Islamic mortgage firm, covering the other 95% (or $95,000). You own 5% of the house, whereas the firm owns 95%. You can purchase 95% eventually from the firm through monthly payments that are comparable to a typical mortgage. This type of mortgage is structured under muhsarakah mutanaqisah structure.

Riba-Free Financing

The riba, or interest, in Islamic home financing, is completely absent. The monthly payment amount for a customer consists of two factors that make one together. A profit payment and an acquisition payment are the two portions.

Both the home buyer and Guidance (an Islamic home financing provider), for example, would have the right to inhabit the property as co-owners, but Guidance grants the customer exclusive enjoyment and use of the entire property. Guidance costs the customer a profit payment in exchange for this exclusive right instead of charging interest.

The Differences Between Islamic Finance vs. Conventional Loan

There is an opinion that says Islamic finance is more expensive than regular home loans. “Islamic Finance is more Expensive” this used to be true; but, as Islamic financing has become more affordable in recent years, it is a myth now. Islamic mortgages are currently more affordable than standard mortgages.

Many home purchasers just do not understand or have sufficient knowledge of Islamic finance to make such a decision. Here are a few crucial elements that demonstrate Islamic house finance’s cost-effectiveness and dispel the idea that it is more expensive than conventional home loans.

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