The Islamic Home Finance (Islamic Mortgage) Guide

1st Ethical Charitable trust guide to Islamic Finance


The 1st Ethical Charitable Trust Guide To: Isalmic Finance

Islamic Finance Explained 3

Ever since the demise of the great Muslim empires, and the subsequent dominance of

Western ideas and policies, Muslims have continually strived to resurrect the tradition of

applying Islamic principles to contemporary issues. Of all the effort being exerted, perhaps

no attempt has been more controversial than the Islamic Finance experiment.

Global Islamic Finance is a market growing at between 10-15% per annum with assets in

excess of $1 Trillion. Many mainstream Western financial institutions have incorporated

departments dedicated to the research and development of Islamic Finance, and many

stand-alone ‘Islamic Banks’ have sprung up over the last few years. These changes are

occurring both in Muslim and in Western countries, and are driven by a global trend amongst

Muslims to become more observant of their faith.

In the UK the Government is actively trying to establish the City of London as the global

centre of Islamic financial activity, and the Bank of England was the first central bank

internationally to abolish ‘Double Stamp Duty’ on Islamic home purchase plans.

Notwithstanding these developments, critics have accused the Islamic Finance industry of

being little more than a talking-shop which at best, is contributing little towards progressing

the real aims of Islamic Finance and at worst is engaged in outright deception.

This guide is an attempt to tackle the ignorance and lack of information surrounding the

Islamic Finance industry by focusing on three crucial issues:

1. To clarify the authentic aims of Islamic Finance;

2. To evaluate the current development of this fledgling industry;

3. To outline what challenges need to be overcome if Islamic Finance is to truly develop

as a viable alternative to Capitalism;

All praise be to Allah, Creator of the heavens and the earth, and Owner of

the Day of Judgement. We bear witness that there is no-one worthy of

worship other than Allah (SWT), and that the Prophet Muhammed (SAW) is

His final messenger.

Key Features of Islamic Finance


1st Ethical: Islamic Finance Explained

Islamic Finance seeks to regulate certain

economic activities in order to achieve the

following objectives;

1. Equitable Distribution of Wealth

An interest based economic system will

always lead to wealth being concentrated

in the hands of the few at the expense of

the many. This is because lenders will

always prefer to loan money to those with

the most collateral, who in turn will use the

money to generate further profits.

Consequently the global interest based

economic system ensures the vast majority

of the world’s finance is commandeered by

a tiny fraction of the overall population.

Islamic Finance has prohibited the

payment of interest when lending or

borrowing capital. Capital must be put at

some sort of risk in order to justify a

return. In doing so banks, and crucially the

underlying account holders, receive a share

of profits and not just a fixed rate of interest.

By engaging in risk and sharing in the

bank’s profits, the underlying account

holders are more likely to receive a far

greater slice of wealth compared with the

interest normally received on deposit

accounts. This in turn would lead to a much

fairer distribution of wealth in society.

The richest 225 people own more wealth

than the poorest 2.5 Billion

United Nations Development Report, 1998

2. The Middle Path

Muslims are required to follow the ‘middle

path’ in all matters. With regard to

economics this can be defined as a path

between unregulated markets on one side

and excessive regulation on the other. While

it is true that Islam rejects the Communist

principle that private enterprise should not

be permitted, it is equally fair to say that

Islam also rejects unbridled Capitalism that

permits individuals to disregard society’s net

interests in pursuit of personal wealth.

The accepted practice of government

economic intervention in capitalist economies

perhaps highlights the fact that certain

economic activities – of harm to the collective

interests of society – should be monitored

and restricted. Islamic Finance is in full

agreement with the ideas of regulating

economic activity but seeks to define the

boundaries through divine guidance.

3. Transparency in Transactions

Islam stresses the need for transparency in

transactions. A sale transaction, for example

requires the existence, quantity and quality

of the subject matter to be clearly stated in

order for the sale to be considered valid.

Islam also compels business transactions to

be put in writing in order to eliminate

ambiguity and reduce the potential for

future disagreements.

4. Asset Backed Financing & the

Nature of Money

Shariah law stresses the importance of only

trading in assets of ‘inherent value.’ Any

asset with ‘inherent value’ can be bought or

sold at a profit, for example a computer can

be purchased for £800 and sold for £1000.

It then follows that an asset without any

inherent use or value cannot be traded, for

example a new £20 note is worth exactly the

same as a used £20 note. The note has no

inherent use in its own right and simply

serves as a determinant of value; hence it

cannot be traded for profit.

Trading in money often leads to detrimental

consequences such as the boom and bust

economic cycle and as such, loaning idle

capital in exchange for a profitable return

runs contrary to Islam’s desired approach.

Islamic Modes of Finance

Modern day Islamic scholars and academics have developed four modes of Shariah complaint

financing that are designed to work within the prevailing capitalist economic framework.

It is true to say that in order to achieve this balance numerous concessions have been afforded

to financial institutions that would not apply if a viable interest free economic system existed.

The stated intention behind making these concessions is to encourage the evolution of just this

type of alternative system.

There is great debate as to whether financial institutions are abusing these concessions and

whether the time has come for these concessions to be revoked in order to enforce the

implementation of genuine Islamic Finance ideals.

Although the following modes are currently implemented mostly within the context of

Islamic home purchase products, they have the potential to be applied to almost any type

of financial instrument or scenario.

1. Murabaha (Cost-Plus Pricing)

In its simplest form Murabaha refers to ‘cost-plus’ pricing, whereby commodities are

bought and then sold at a predefined marked-up price.

Murabaha is very popular with banks because it facilitates charging higher prices on

deferred payment terms.

Critics would point out that the timeline between the purchase and the sale is likely to be

the time it takes to sign the two contracts. As a result, the bank experiences an extremely small

amount of risk in exchange for a comparatively profitable return on an asset-backed basis.


A client approaches the bank with the details of a property they wish to purchase. The client

signs a ‘promise to purchase’ agreement with the bank before the bank purchases the property.

The banks carries out due diligence on the property before purchasing the asset. Before selling

the property to the client the bank marks up the price of the property. The client enters into an

agreement with the bank to purchase the property for a fixed price over a fixed period of time.

The bank buys the property and sells it to the eventual purchaser in a ‘back-to-back’ transaction

that is conducted almost instantaneously.

2. Ijara (Leasing)

Ijara is probably best understood in the context of current Islamic home purchase products.

Having said this, any qualifying commodity can be leased at a fixed cost. Ijara based plans

require banks to purchase the property identified by the eventual home owners who are in

turn required to reside in the property as tenants over a fixed period of time. Rental

payments are accompanied by ‘on account’ payments which accrue in a separate fund.

At the end of the tenancy agreement the monies accumulated in this fund are used to

purchase the property outright. This practice involves the bank promising to sell the asset

to the tenant at the out-set. Under Shariah this promise is treated differently to the tenancy

contract itself. This distinction is crucial as Shariah law prohibits the concept of operating a

contract that is contingent on the implementation of a second contract.

Islamic Modes of Finance


1st Ethical: Islamic Finance Explained

Ijara Continued…

The bank also agrees to sell back the property at the original purchase price, not its market

value at the time of sale. This is also normally against Shariah but has been permitted

where the asset is not for business use (e.g. home).


A client approaches a bank with the details of a property they wish to buy and move into,

but cannot afford to do so.

The banks carries out due diligence on both client and property before purchasing the asset.

The bank then assumes ownership of the property and the client enters into the tenancy

agreement with the bank. Monthly payments to the bank consist of rent and an element

towards the purchase the property. Capital accumulates ‘on account’ with the bank and at

the end of the tenancy agreement will amount to the same sum the bank originally purchased

the property for. The client may exercise their promise to purchase sooner if they have

the funds available. At this point the client purchases the property with the ‘on account’ funds.

3. Musharaka – Joint Venture Financing

Musharaka is the most desired form of financing in the eyes of Islamic Finance. All the essential

elements promoted by Islamic Finance are to be found at the forefront of a Musharaka contract

– the absence of interest, the presence of risk, the spirit of sharing profits and proportionate

losses, and the direct link between capital investment and underlying asset based transactions

In practice Musharaka involves a bank obtaining an equity share in an asset or business in lieu of

a conventional loan. Some of the basic rules of Musharaka are as follows;

• Profits are shared as per the agreement of the partners whilst losses are shared on a

pro-rata basis against the investment.

• Contribution to the Musharaka fund can be via liquid assets or illiquid assets. Once the

assets are in the fund they are pooled for the benefit of all partners.

• Sleeping partners must take a share of profits in direct proportion to their initial investment.

4. Modaraba

Modaraba ranks alongside Musharaka as one of Islamic Finance’s preferred financing methods.

Modaraba also embodies the spirit of profit-sharing as well as active management of capital

linked to assets. Modaraba differs from Musharaka in that contributions made by the partners

consist of capital investment or expertise rather than just capital investment. This combination

of capital and expertise is then employed into profitable ventures.

The three key rules governing a Modaraba contract are;

• The percentage share of profits must be fixed in advance. A percentage of profits can be

specified as return, but not a percentage of capital investment as this would be akin to interest.

• In the event of a loss occurring, the Rabb-ul Maal (investor/owner of capital) solely bears

this burden. The Modarib (expert) does not need to contribute towards the loss.

• It is perfectly acceptable for the Modarib to take genuine expenses incurred out of the

Modaraba fund, but is not however permitted to take a salary.

Islamic Modes of Finance

1st Ethical:

Islamic Finance Explained 7

Diminishing Musharaka (DM) –

Recent times have witnessed a shift in emphasis away from

Ijara towards Diminishing Musharaka (DM) as a mode of financing Islamic home purchase

plans. Many of the major providers have either switched to DM or are planning to do so

imminently. DM is a hybrid financing technique involving both Ijara and Musharaka

elements. Murabaha, Ijara, and Diminishing Musharaka are Shariah compliant modes of

finance that rely on concessions that enable them to ‘fit’ into a modern day interest based

economy. Scholars and academics have permitted these modes on the condition they are

a stepping stone to true Musharaka/Modaraba financing. Banks are, however, very

reluctant to embrace Musharaka financing as this requires them to accept the risks

associated with equity financing and move away from the guaranteed income they crrently

enjoy. Critics of Islamic finance suspect banks will never adopt Musharaka and therefore

question the wisdom in permitting the concessions on which Murabaha, Ijara, and DM

rely. Investment banks and venture capital firms do offer equity based finance, but only

deal with the higher risk end of the market that is defined by those with insufficient

collateral to obtain conventional interest based finance. Investment banks are therefore

able to charge much higher rates of return than those available from conventional interest

based banks. Other commentators are of the view that as contemporary Islamic financing

has only been in existence for three decades or so, and considering that the interest

based capitalist system has taken several centuries to evolve to its present form, it is

premature to pass judgment on the banks’ ability, or lack thereof, to embrace the true

spirit of Musharaka/Modaraba.


The client identifies a property they wish to purchase over a fixed period and enters into a

DM agreement with the bank. In this arrangement the bank purchases the property and

agrees to sell it to the client ‘piece by piece’ over a fixed period. The monthly payments are

similar to the Ijara plan except ‘on-account’ payments (see Ijara example) are used to

purchase additional equity in the property. This occurs during the term of the contract

rather than having to wait until the end of the contract. When the final share in the property

is purchased by the homebuyer, the house becomes the sole property of the homebuyer.

DM is superior to Ijara in that it confers actual ownership of the property (albeit in stages)

much quicker than an Ijara arrangement which only transfers the asset at the end of the

home finance term.

Historic Overview of the

UK Islamic Finance Market


1st Ethical: Islamic Finance Explained

The Early Years (1996-2001)

The United Bank of Kuwait (now known as Ahli United) launched the first ever Islamic home

finance product (Manzil) back in 1996, which was based on a Murabaha contract. Initially takeup

of the Manzil product was slower than expected which was largely down to the unfamiliarity

of the concepts amongst the British Muslim community. The bank was however assisted by the

presence of a well known Islamic Finance scholar, Mufti Taqi Usmani, on their Shariah advisory

board. To date Ahli United has sold nearly 1,000 such home finance plans. Ahli United was a

lone provider in the Islamic home finance market in the early years and attracted a lot of

criticism for being too expensive and restrictive.

The Due Diligence Period (2001-2003)

By 2001 many of the major banking institutions began to recognise the commercial potential

of the global Islamic Finance market and started developing products of their own. Owing to

the inflexibility of the Murabaha product the Shariah scholars allowed banks the additional

choice of the Ijara contract.

Governmental Support (2003- )

The purchase and resale required for Islamic home purchases resulted in double stamp duty

which significantly increased the costs of Shariah compliant financing. Under pressure from the

Bank of England, numerous Islamic organisations and financial institutions, the Government lifted

the double stamp duty barrier in 2003. This historic decision paved the way for many institutions

to develop commercially viable home purchase products, and cemented the UK’s leading role in

the global Islamic Finance industry.

The UK Islamic Finance Boom (2003- )

HSBC’s decision to launch ‘HSBC Amanah’ heralded the entry of mainstream banks into the

Islamic Finance arena. Soon afterwards NatWest launched Alif Baa Taa (ABT) commercial

finance based on the Murabaha model along with the Bank of Ireland. Thereafter United

National Bank, Arab Banking Corporation (Al-Buraq) and Lloyds TSB all established Shariah

complaint product offerings.

Shariah scholars then devised the concept of Diminishing Musharaka (DM) that enabled

clients to buy back shares in a house from the bank at regular intervals, rather than at the end

of the contract as was the case with Ijarah. The launch of DM represented the introduction of

a product that could be favourably compared on cost and flexibility with conventional interest

based loans. It is worth stressing DM was only achieved as a result of the experience gained

from the earlier introduction of Murabaha and Ijarah.

At around the same time a unique community collective known as Ansar Finance

(Manchester) started offering Islamic home finance to its members. The key difference

between Ansar and just about all the other Islamic home finance providers was that Ansar’s

seed finance was from its members who were mainly from the Muslim community. This won

Ansar many plaudits from the Muslim community.

1st Ethical:

Islamic Finance Explained 9

High Street Islamic Bank and the Musharaka Fund Launched 2004 – 2006

2004 witnessed the launch of the UK’s first stand alone bank completely based on

Islamic principles – The Islamic Bank of Britain (IBB). The UK underscored its position

as the first Western country to grant a licence to a fully-fledged Islamic bank. IBB initially

started its product offerings with regular current and savings accounts but then rapidly

moved into personal finance and is now contemplating a number of Shariah-compliant

products. It has over 12 branches nationally and it is expected to grow rapidly.

The second development worth noting came in 2005 when 1st Ethical Limited launched the

‘Musharaka Fund’. This fund invited investment from the UK Muslim community and then

reinvested those funds as venture finance into UK Muslim businesses such as dental practices,

optical practices etc. The launch of the fund was the first serious attempt to implement pure

Musharaka and move away from the concession approach favoured by the conventional banks.

London – The Global Centre for Islamic Finance (2006- )

During a landmark speech at a major international conference on Islamic Finance in June

2006, the Chancellor Gordon Brown declared his desire to see London become the

international global centre for Islamic financial activity. He also fully pledged his support to

any legislative changes required in ensuring a level playing for Islamic products. The FSA

(Financial Services Authority) has also taken a keen interest in this area and dedicated

specialist resource to help develop the requisite regulatory framework.

Summary – What Does the Future

Hold for Islamic Finance?


1st Ethical: Islamic Finance Explained

There is undoubtedly a growing demand for Islamic financial products both in the

UK and globally. The success of the Islamic Finance industry in meeting this

demand will depend in great measure on overcoming the increasingly sceptical

reaction of Muslims to the permissible nature of the products being offered. This

scepticism in turn will only be successfully overcome if banks can embrace risk

and move towards Musharaka based solutions.

Progress has undeniably been made over the last three decades, albeit principally in

developing home purchase products. In the short term there will be an increasing choice in

bank deposit, credit card and investment products. It seems that Islamic Finance will move

critically towards the much desired goal of allowing Muslim consumers to have a full

portfolio of suitable financial products. The likely sponsors of this shift will be the existing

Islamic ‘windows’ within conventional banks alongside standalone Islamic banks and

private/community-based initiatives.

Western investment banks and venture capitalist firms appear to converge with the

Musharaka model far better than conventional interest based banking. The next stage in the

process will require the development of Shariah compliant investment banks that operate on

a genuine equity basis, albeit with those clients who do not have already access to

conventional finance. This is where the Islamic Finance experiment is currently. Given the

investment banking model is well established, there is every reason to expect this stage to

be achieved in the next few years.

Moving on from this stage will be much tougher as it will require the application of equity

based finance to clients who do have access to conventional interest based finance. This will

mark a step into the breach, with investment banks being forced to compete with interest

based banks for the same business. It will be embarked upon

only by those who are implementing Islamic Finance as part of

their faith, and not solely as a business venture. Developments to

date have allowed the Muslim community to overcome many

hurdles that have resulted in true Musharaka now appearing in

the distant horizon.

We conclude by praying that the Almighty (SWT) is pleased with

this guide, and makes it a means through which the true message

of Islamic Finance can be easily understood and implemented.

Any mistakes are due to our weakness, whilst any guidance can

only come from our Creator (SWT).

Frequently Asked Questions

1st Ethical:

Islamic Finance Explained 11

What follows is a list of four commonly asked questions. You are advised to read the

literature on 1st Ethical’s website for further information.

1. Why do Muslims need an alternative to the

prevalent interest based financing system?

Any financial system which seeks to organise

and regulate people’s affairs should be

equitable and just. Muslims are by no means

alone in highlighting the countless fallacies in

the present interest based system; a system

which rewards those who possess capital over

those who take risks, a system which has a

persistent tendency to favour the rich over the

poor, and a system which has successfully

indebted at least half of the world’s population.

Such a system can never claim to be equitable

or just. In fact, Islam, like many faiths, has

banned interest. Parts of the Bible still bear

reference to the prohibition of usury. The

Church was locked in an intense battle with the

banking fraternity over the legitimacy of

interest before the Church ultimately lost and

banking quarters prevailed.

At its heart Islamic Finance divorces capital

from an inherent right to return. Instead the

factor of entrepreneurship must be present for

a return to be justified. Risk-sharing, profit

sharing, ethical investment, social

considerations and transparency in transactions

are all hallmarks of the Islamic financial system.

2. Both conventional finance and Islamic

Finance result in a profit for the bank. What is

the difference between profit and interest?

Just because two transactions may yield the

same end result does not make them identical

in the eyes of Shariah. What needs to be

studied carefully is the underlying mechanics

behind each transaction and their compliance

with Shariah.

Just because two transactions may yield the

same end result does not make them identical

in the eyes of Shariah. What needs to be

studied carefully is the underlying mechanics

behind each transaction and their compliance

with Shariah.

3. Many Islamic banks link the repayment of

Islamic home finance to the prevailing interest

rate – surely this is Haraam?

Interest in all its forms and guises is despised

in Islam and forbidden as part of any

transaction. Linking investment return to the

interest rate is also discouraged BUT is not

prohibited in Islam. Why? Because there is a

fundamental difference between interest per

se and a transaction which has its return

linked to interest. Islamic scholars cite the

following example to illustrate the point.

Imagine two brothers running separate

businesses. One brother unfortunately

decides to deal in liquor (totally prohibited in

Islam) whilst the other decides to open a

hardware store. If the brother with the liquor

store sets himself a profit target of 15% per

annum then all this profit is prohibited

(haraam) in Islam as his underlying trade of

dealing in alcohol is prohibited. If however his

brother dealing in hardware looks at the profit

margin of 15% in the liquor trade and decides

to peg his return in hardware to 15%, one can

say this is undesirable but can never claim it

be Haraam, simply because the underlying

activity being conducted (hardware sales) is

implicitly Halaal.

4. Why are Islamic products usually more

expensive that their conventional counterparts?

Price differences are in part due to higher

research and development costs, as well as

banks requiring a ‘risk-premium’ from an

untested new product. There are also extra

Shariah-compliance and monitoring costs

involved. These costs will diminish over time

as Islamic Finance becomes more

mainstream. The ever increasing level of

competition also helps drive down prices.

It is true to say that the allegation of Islamic

Finance products being too expensive is

much less of an issue today than it was a few

years ago.

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Who are 1st Ethical Charitable Trust?

The 1st Ethical Charitable Trust is regulated by the Charities Commission and is funded by British

based (non-governmental) donors. In addition to providing humanitarian relief, the 1st Ethical

Charitable Trust is dedicated to encouraging social and religious cohesion in the UK by promoting a

distinct British Muslim identity which on the one hand, is faithful to traditional Islamic orthodoxy whilst

on the other, is also in tune with British cultural norms and values.

Historically, the Trust has tried to achieve this vision by developing Shariah-compliant solutions to

common legal and financial challenges facing British Muslims. In this regard, the Charitable Trust

operates an extensive Online Knowledge Base and produces publications on Zakah, Islamic Wills,

Shariah-compliance, Prohibitions of Interest etc. For more information, please visit

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