“It is surely a good idea to explore how the sprit inherent in the “moral economy” of Islam could enable a just and ethical approach towards the management of systematic risk in economics, in business and finance the way risk-sharing, implicit in Musharaka, works, for example, with lenders sharing the borrower’s risk, and the notion of Mudharabah, the sharing of profit. This is very different from the way that conventional finance transfers the risk quickly and frequently onto someone else with profit going just one way.”
This statement by the Prince of Wales aptly describes what Islamic financing is and its competitive advantage over conventional financing. With the current pace of globalization and technological advancement, Islamic financing is growing rapidly globally. Indeed, like other forms of financing, residential mortgages can also be financed using either conventional or Islamic financing. Undoubtedly, the Islamic model of mortgage financing is not widely known as most banks offer the conventional residential mortgage financing. It is against this background that this article examines what Islamic mortgage financing is, the Islamic rules relating to mortgage contracts, the various types available as well as its comparative advantage over conventional mortgage financing.
Overview of Islamic mortgage financing
Islamic mortgages are becoming very popular globally especially amongst the Muslim faithful’s. Indeed, their preference for Islamic mortgages is primarily because of the dual benefit of, being able to own a home through financial means which agree with one’s religious beliefs. In addition, traditionally, the preferred financing for acquisition of homes in the banking industry is mortgages. Furthermore, house financing is very close to the spirit of the Islamic financial system as it enhances the promotion of equitable distribution of wealth, and financial stability.
The most popular financing tools used by Islamic Financial Institutions (IFIs) for the provision of mortgage financing is provided under the principles of a special purpose partnership generally known as Diminishing Musharaka. Other Islamic financing tools include Musharaka (partnership in capital), Mudaraba (partnership of capital and skill), Murabaha (cost plus profit sale), Bai Salam (spot payment with deferred delivery), Bai Muajjal (credit sale), Istasna (order to manufacture) and Ijara (leasing).
Islamic mortgage finance differs from conventional mortgage finance in the following ways:
- IFIs are co-owners of the property and share the risk and rewards attached with ownership of the property. Hence, any damage or loss occurred to the property without negligence of client is shared by IFIs according to their equity stake.
- Unlike conventional banks when returns are earned from the date the mortgage facility is granted, under the Diminishing Musharaka, return only becomes due when the property is ready for use either through an acquisition or through construction.
- Whilst conventional banks will continuously receive the repayment installments (comprising of interest & principal) even if the property is not useable and needs some repair, IFIs are not entitled to rents during the period of repair.
- while IFIs will only receive rentals and share any appreciation or depreciation of the property, conventional banks’ returns on the mortgage facility are typically fixed as interest for the tenor of the facility.
Islamic Rules relating to mortgage contract
The Islamic mortgage contract is derived from the elements of general Islamic contracts as the Qur’an does not mention the mortgage contract explicitly. The Qur’an, in its verses, contains many rules and principles on contracts in general, and these are applied to create a mortgage contract based on Islamic principles.
Indeed, the Qur’an permits any kind of contract as long as the terms of the contract do not contradict basic Qur’anic rules, especially the one about interest (Riba), which is strictly prohibited. Based on the Qur’anic analogy, an Islamic contract has the same general elements as the English contract, such as offer, acceptance, the complete satisfaction and consent between the parties (the meeting of minds) and the extreme importance of mutual fulfilment, that has been emphasized in many verses of the Qura’an such as Qur’an Sura: Al-Rum, 30:39; An-Nisa’a, 4: 29, 161; Al-Imran. 3:130; Al-Baqarah, 2: 275- 81; Al-Ma’idah, 5:1. So, whilst the Qur’an does not expressly make provision for mortgages, it can be classified as a sale or as part of trade operations which implicitly include buying and selling under Qur,an Sura: An-Nisa’a, 4:29; At-Tawbah, 9:24, An-Nour, 24:37; Al-Jumu’ah, 62:11.
Prohibition of Riba (Usury)
The prohibition of Riba or usury is very key in all Islamic contracts, including mortgages. In Arabic, Riba means an amount that is charged to the borrower on the loan without an equivalent counter value or recompense in return to the other party. It covers interest both in commercial and consumer loans. Indeed, Riba is prohibited in many verses (Ayat) of the Qur’an such as Qur’an Sura: Al-Rum, 30:39; An-Nisa’a, 4:161; Al-Imran, 3:130; Albaqarah, 2: 275-80.
Consequently, to avoid the inclusion of Riba (usury) in a mortgage contract, the property must be owned by the bank or the financial institution. In other words, the financial institution would buy a property at a certain price (exactly like any other buyer or trader). When the bank becomes complete owner of this property, it would then be resold at a higher price to any client who would like to buy this specific property. This prospective buyer shows his or her interest by submitting a documented or written promise to the bank assuring the banks that he will re-purchase the property. There is no interest at all because the price is not changeable. Whatever happens after the sale agreement has been executed would not result in any increase in the price of the house. In addition, there is no room for any speculation such as monthly interest rate change. Everything completely relies on the agreed price in the contract, whether payment will be after five years or twenty. So, essentially, the bank deals with property as an original owner and sell the house directly to the client based on the payment of instalments or some other mode of Islamic mortgage. For this purpose, the Qur’anic teachings provides some guidance such that there are methods of commercial dealings or transactions which allows people to offer their products at two different prices. One, the buyer pays the original price for cash payments, and two, a higher price for deferred payments, the latter being subject to one condition, that the buyer cannot be charged any money by the seller where there are arrears as this will be considered interest, which is prohibited under the Qur’an.
The different types of Islamic mortgage financing
Whilst any of the asset-based contracts including Murabaha and Ijarah can be used for the provision of residential mortgage financing, the Musharakah (financing through joint ownership with the customer) is utilised mostly by IFIs for financing residential mortgages. These asset-based contracts are:
Under a Murabaha, the IFI purchases a property on behalf of the customer and ‘re-sells’ it to it for a profit. The buyer then repays the IFIs through monthly or yearly instalments. The property is registered in the IFI’s name as a form of collateral until all mortgage payments are complete. It is important to note that one of the advantages of a Shariah-compliant home loan is that there are no additional interest payments for late payments though the IFI may charge a fixed fee. The table below provides an illustration of how the Murabaha works.
|Cost of property from third party|
|Term of finance||25 years|
|The IFI will purchase the property and immediately resell to the customer for a fixed price|
|The portion of the purchase price payable by the customer on day one|
|Balance on the purchase price to be paid in 25 equal installments over the term of the financing|
|Frequency of customer’s installmental payment||Once a year on the anniversary of the purchase.|
Another Islamic financing model that can be used for mortgage financing is the Ijarah, which is a buy and lease-back arrangement and preferable if the buyer is buying a property off plan as no payments are made until the property is completed. So, essentially, the customer chooses a property and agrees a purchase price with the seller. The customer thereafter applies for an Ijara mortgage and agrees repayment terms with the IFI and enters into a contract with the IFI such that he agrees to repay the purchase price through fixed monthly installments. He also agrees to pay an agreed amount as rent to the IFI. However, the rental decreases annually as the mortgage loan decreases with the payments made by the customer. Once the purchase price has been paid in full, the IFI transfers ownership of the property to the customer.
The Musharakah form of Islamic mortgage is an innovative mode of financing called Diminishing Musharakah (DM). According to Sharia standard 12 Diminishing Musharaka is a form of partnership in which one of the partners promises to buy the equity share of the other partner gradually until title to the equity is completely transferred to him. Furthermore, under the Diminishing Musharaka, a verbal or written agreement is required, capital is contributed by both parties in cash or kind, profit is shared as per agreement while loss is shared according to share in equity, cost of repair and maintenance, insurance etc. are shared by the parties and one partner (IFI) leases his share in the asset to the other partner (customer) for a consideration. It is important to note that contract of buying and selling of equity units between partners cannot be reduced into a Diminishing Musharaka contract because the price of the units to be sold /purchased is fair value or else as agreed between parties but the face value price of the units cannot be stipulated.
With this method, the property is purchased under the joint ownership of an IFI and the customer, a particular portion of the cost of the property, usually 15% to 30%, is contributed by the customer and the remainder financed by an IFI. The property is purchased under a joint ownership or in some instances, in the name of the customer alone for legal and tax reasons. Use of the property is exclusively for the customer. Thereafter, the IFI’s equity stake is distributed in a large number of small units (usually equal to the number of monthly payments), and the customer is required to buy these equity units from the IFI at an agreed price at the time of acquisition. In addition, a rental income for the property would be agreed between the customer and the IFI which the customer would be required to pay monthly in respect of the use of the property, to the bank. Once the customer has completed the purchase of all equity units from the IFI, ownership of the property is transferred to the customer and the project is closed. So, essentially during the period, IFI receives from the customer the principal amount incurred for the purchase of the property and the required return. This is further illustrated in the table below:
|Cost of property from third party|
|Term of finance||25 years|
|Customer to initially provide|
|IFI to provide|
|Rent calculation||Rent to be calculated by multiplying the original cost of the portion of the property owned by the IFI|
|Rental rate adjustments date||The rate can only be adjusted at the end of each year|
|Frequency of customer payments||Once a year from the anniversary of the purchase of the property|
|Price at which the customer will buy the IFI out||Price equal to the original cost of the property to the bank|
|Customer to make equal annual repayments which is comprised of rents for use of the property and part payments to acquire the bank’s share of the property.|
Islamic Mortgage financing in Nigeria
Islamic banking started in Nigeria in 1982 and during this period there was no legal framework to regulate Islamic financing. However, with the amendment of the Banks and other financial Institutions Act in 1991, the Act recognised specialised banks such as non-interest banks/profit and loss sharing banks. Pursuant to this amendment, the Central Bank of Nigeria (CBN) issued the Guidelines for the Regulation and Supervision of institutions offering non-interest financial services in Nigeria, 2011. This regulation required all non-interest financial institutions to be licensed by CBN. Furthermore, in 2011, the CBN issued the Guidelines on Shariah Governance for non-interest Financial Institutions in Nigeria which required compliance with shariah principles a critical element of non-interest banking and finance. Indeed, in other to ensure compliance with the shariah principles, the Shariah Advisory Committee(SAC) was also established and saddled with the responsibility of ensuring compliance with shariah principles at all times.
It is interesting to note that in spite of the foregoing, Islamic financing and Islamic mortgage financing is still at a nascent stage in Nigeria. It can be argued that the following factors have been responsible for this:
- Lack of Awareness: most of Nigerians are unaware of Islamic mortgage financing. This is partly because the product is new and only offered by one bank with limited branch network in the country. Creating awareness is a major step in promoting the operation of Islamic mortgage in Nigeria.
- Unfavourable Regulatory Framework: Before now, the regulatory framework for home financing favoured conventional banks as it was structured in accordance with the conventional financial system which allows the CBN to give commercial banks loans with interest, which is against the tenets of Islam as highlighted above. However, as part of its drive for economic development, the CBN has recognized the need to make funds available to non-interest financial institutions taking into consideration the peculiar nature of their financing requirement. For this purpose, the CBN released the Revised Guidelines for Non-Interest Financial Institutions 2020 where the CBN introduced several intervention Schemes to expand the financing pool for Non-Interest Financial Institutions. The sectors covered by the schemes include the agricultural sector, textile sector, Agri-business, real sector, credit support for health care sector amongst others.
- Religion and Cultural Disparity: Nigeria is a multi-faith based country and as such, there are varying perceptions about Islamic financing products including Islamic mortgage financing. Perhaps, this is the foremost reason for the rate of growth of the Islamic financing industry in Nigeria and the level of acceptance of their products. Therefore, there is need for awareness so that people are able to separate their beliefs from the need to benefit from the advantages Islamic financing has over conventional banking.
From the foregoing, it is clear that,
“Islamic finance is based on the principle that the provider of capital and the user of capital should equally share the risks of business ventures. It encourages sanctity of contracts, sharing of risks, prohibition of interest and speculative trading, and gambling. Islamic theories of finance encourage earnings through participation in business activities and discourage the avenues of unearned income.”
Indeed, there is no doubt that financing a residential mortgage through the asset-based financing techniques highlighted above trumps conventional financing for the achievement of the same objective.
Written by Love Olayemi
The information and opinions in this publication are provided for general information only. They are not intended to constitute legal or other professional advice. If you would like additional information, please contact the author at [email protected]
© All Rights Reserved. Sefton Fross is a leading full-service law firm in Nigeria internationally recognised for its expertise in corporate, commercial and mergers and acquisitions.