How Islamic banking differs from conventional banking.
Islamic principles dictate that money lending (dealing with interest) as well as investing in businesses that are considered haram (unlawful) are prohibited. Islamic finance is all about accumulating all the available resources (from savings) and providing financing based on pre-determined profits rather than dealing with interest.
All the available resources will be utilised by Islamic banks to provide financing through either buying, selling or leasing. Islamic banks are required to buy an asset (including real estate) and lease it to the customer through a co-ownership agreement where the customer pays 10 per cent downpayment (customer’s equity) and the bank will finance the balance of 90 per cent (bank’s equity).
On the assumption that the customer occupies the house, the bank will rent its 90 per cent equity (share) to the customer who pays rent for occupying the bank’s equity.
The title of the property is still in the customer’s name although the asset is co-owned within the contractual agreement. The customer holds 90 per cent of beneficial ownership with the bank acting as trustee.
During the amortising period, the bank will transfer its equity to the customer over time. Therefore, as compared to conventional banking, the transaction is not considered as a property loan but more as property financing based on co-ownership principles.
The differences are based on the principles attached to each system – halal vs haram, interest vs profit, loan vs financing and ownership vs co-ownership.
Advantages or weaknesses of Islamic mortgage v conventional mortgage?
Advantages of Islamic mortgage.
• Fixed payment – fixed monthly payment will help the customer to balance their monthly budget.
• Stamp duty – Since 2007 Budget, it is cheaper by 20 per cent as compared to conventional loan. Stamp duty is waived for the redeemed amount when refinancing from a conventional loan to an Islamic home finance.
• Penalty fee – whilst conventional loan’s penalty fee for early settlement (prepayment) is set at a certain percentage, the Islamic bank will charge based on the bank’s prevailing cost of funds. However, the fee differs from one Islamic bank to another.
• Interest rate cap – Islamic banking is based on Base Financing Rate (BFR) which the bank can actually adjust (the rent) based on the prevailing market conditions but not more than the ceiling rate (cap rate), i.e. the maximum profit an Islamic finance provider will earn.
As such, when the BFR changes due to changes in economic conditions, the price of property and financing will also change. However, the BFR will be constant regardless of the location of the property. There is no interest rate cap for conventional loans.
The main weaknesses of Islamic property financing are:
• Penalty rate – Although floating rate for the penalty may be attractive at some point in time but it is less desirable during the high interest rate regime.
• Uncertainty of the numbers – although the Islamic financing concept sounds acceptable, the basis of calculation between one bank to another differs significantly. .
• Alteration of terms of financing – should a customer choose to alter the terms of financing, a new Sale and Buy-back agreement needs to be created and signed. A conventional loan would only require the amendment to be stamped which incurs cheaper cost.
How does the financing work in terms of property purchases?
The profit is normally calculated upfront prior to approval of home financing. The calculation of the profit is similar to conventional loan which is based either on monthly or daily rest. The calculation of monthly instalment is also based on similar mathematical model used for conventional home loan for the whole length of the amortisation period. The only difference is the rate used for conventional home loan is Base Lending Rate (BLR) whereas Islamic financing is based on Base Floating Rate (BFR).
Once the profit is determined, the sale price will be established to include the principal. As in most conventional fixed rate loans, the monthly instalment in fixed-rate Islamic financing does not change throughout the amortisation period. Therefore, a decrease in the profit rate will result in surplus (rebate) to customer which directly shortens the length of the financing. In a variable rate Islamic finance, any decrease in the profit rate will either shorten the tenure of the loan or change the instalment amount.
Any individual Islamic bank will produce different figures due to certain requirements imposed such as zero entry cost as well as the prepayment penalty. The basis of calculation between the banks will also produce different results and it is entirely up to the customer to shop around before they make up their final decision.
Statistics to show more homebuyers opting for Islamic over conventional housing loan
Statistics show that Islamic home financing has grown over 30 per cent in the last five years as compared to conventional of around 11 per cent. The majority of demand would come from the Muslim population.
When a borrower defaults in his Islamic housing loan, what happens?
Islamic banks are more considerate as they would give more time to the customers according to the Islamic way of life. During this difficult time, the banks are not supposed to impose further burdens on the customer. The late payment charges are normally about 1 per cent, which is lower than conventional banks. In a worst case scenario, there is no difference in the final recovery process where both banks have the right to foreclose the transaction through auction.
