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The Great Mortgage Caper?

Tarek El Diwary - April 2003

For individuals who buy houses using interest-bearing loans, the housing market can be a highly profitable place because, as lending institutions pump money into it, the price of houses increases but the debt that was borrowed in order to buy each house remains fixed in nominal terms. If house prices go up very fast the ratio of mortgage to house value can decrease very rapidly, thereby making the home owner richer in money terms should he or she wish to sell the house and repay the mortgage. Hence, many businessmen try to make profit by: a) borrowing money at interest; b) buying property; c) renting the property to a tenant for a while; d) selling the property; e) repaying the debt; and f) taking the surplus as profit. As long as the rental yield on a property plus the rate of price increase continues to exceed the rate of interest on the loan that was used to purchase the property, such businessmen continue to make profit.

The beneficiaries of the lending institutions' activity are firstly the lending institutions themselves (because they earn interest on their loans) and, secondly, property speculators (whose net assets increase during times of property price inflation). We should recognise too that many existing homeowners do not actually gain anything from increasing house prices. If I sell my house today and move to another house, price increases do not benefit me at all because although I sell my existing house more expensively than I bought it, I must also pay more for the next house that I purchase.

Nevertheless, there are advantages to renting which must not be overlooked. These include the ability to quickly leave a property and move somewhere else, freedom from maintenance worries, and the freedom from mortgage debt. For a sincere Muslim, the freedom from the sin of paying interest is of greater importance than all of these.

If a Muslim does wish to buy a residential property, and if he or she has decided that it is better to buy now than wait for a fall in house prices, the question now arises as to how to arrange finance. In this respect, and given that few are fortunate enough to have sufficient savings at their disposal, much of the Muslim community has been glad to hear of the recent appearance of Islamic mortgages in the UK market. It is widely believed that these financing schemes will finally allow Muslims to become part of the "property owning democracy", and escape the economic trap of long term rental. On account of this development UK lending institutions are of course very happy too, because the existence of an "Islamic" mortgage allows them to lend to a hitherto unexploited market, the Muslim market, and thereby make extra profits.

Having noted that Islamic home finance does not necessarily imply an Islamic mortgage (family and friends may not seek a mortgage on your property if they are the ones providing the loan), the following is a brief description of the three models of Islamic house financing currently in existence in the Western world generally, and in the United Kingdom specifically.

A number of Shariah problems relating to the above transactions have been discussed in recent years. In the Al Ahli Ijara model for example, rental levels are reset yearly in line with market interest rates. Although scholars have argued that this in itself is not haram (why shouldn't I make the same percentage of profit selling my lemonade as the chap next door makes selling his beer?) the fact is that the client does not know what rental he has contracted to pay to the bank until the beginning of each new year. If interest rates increase dramatically, then the Ijara rental rates will likewise increase, and the client could well find himself locked into the payment of lease rentals that he cannot afford. This is one basic reason that traditional scholars in Islam have made the specification of price a basic requirement of any sale contract. (How can I agree to buy something if I don't know the price?) Furthermore, if the client decides that he can no longer afford the rental, the Al Ahli contract requires that he must guarantee to repay the amount of finance initially provided by the bank. In those cases where the house has to be sold to achieve this, the possibility arises that, if property prices have fallen in the meantime, the sale proceeds may not be sufficient to repay the financed amount. In this case, the client is required to make up any shortfall to the bank, and the awful prospect of "negative equity" arises for the client ... a position in which the client owes more in debt than his house is worth.

Furthermore, conceptually, it should be obvious that the client can only be renting the property if he doesn't own it. Yet if the Al Ahli product really is a rental, why does the client have to bear the risk of a fall in the price of the property? On the other hand, if the client is bearing this risk because he owns the property, then why is he paying rental to the bank? Perhaps the case is that the client and the bank both own part of the property, but the Al Ahli contract makes it clear that the bank owns the house in its entirety until the final payment on account is made by the client, and only at that time will title be transferred to the client. The truth of the matter here is that the core Islamic contracts of sale and rental have been mixed together so that neither bears integrity any longer. The danger of such mixing should be obvious from a consideration of what would happen if an Islamic money lender was allowed to combine hiba (a gift) with qard (an interest-free loan) and a promise, all three of which are acceptable contracts in Islam. The money lenders' clients could then be asked to promise to give the money lender a gift upon repayment of any interest-free loan that he made to them. That would clearly be a case of interest, but the contract documents would never need to mention the word "interest".

The third model of home financing to be made available in the United Kingdom is the diminishing partnership model. This model has been tried and tested over many years in Canada by the Islamic Co-operative Housing Corporation Limited, and has been recently introduced into the UK by Ansar Finance in Manchester through Ansar Housing Ltd. Here, a prequalification period is required in which each client purchases shares in the house financing organisation in order to gain the right to apply for house financing at a later time. Funds raised by the organisation in this manner are used to finance other clients who have completed their prequalification periods. When the client has qualified for house financing, Person A (the house financing organisation) buys the house in its name from Person B (the house seller). Person C (the client) then becomes a partner of Person A in a nominal partnership vehicle which is deemed to own the property ("nominal" because the name of this partnership vehicle does not appear on the property's title deeds). For this purpose, Person C transfers the value of his prequalification shares in the organisation to the partnership vehicle, and the relative size of Person A's and Person C's contributions determine the ratio of their shares in the partnership. Person C now lives in the house and pays rent to the vehicle. The rent is then distributed among the shareholders of the vehicle, which of course include Person C himself. Over time, Person C buys Person A's shares in the vehicle and eventually comes to own all of them. At this stage he is the full nominal owner of the house and therefore pays all of the rental on the property to himself. The final formal step is then taken of transferring title in the property to the client, following the making of a special final payment (see next paragraph) between Person A and Person C.

The most common implementation of the diminishing partnership scheme is one in which the rental levels and the purchase price of each share is fixed at the outset of the contract (rather than being related to market values at each point in the future). Models in which the purchase price of the shares has to be made at a price reflecting the property's market value at the time of purchase have not been well received by potential clients. This is presumably because clients know that house prices tend to rise over time and, therefore, that it is not in their interest to pay a price that reflects the market value of the property each time they want to increase their holding of shares. The disadvantage of such fixing is that the people who invest in the organisation's shares are often those who are doing so in order to save the deposit for their own house. If the organisation's property assets are sold off piece by piece at prices that were agreed several years previously then, given that property prices tend to rise, those assets will tend to be sold at below market value. This of course is a rather poor commercial deal from the point of view of the scheme, and in turn for the savers whose money has financed it. The fairest deal is for each sale of shares to take place as close to market value as can be achieved with cost efficiency. To this end, the Ansar Finance product attempts to some degree to share gains or losses in the capital value of the house among the partners (in a pre-agreed ratio) when the nominal partnership comes to an end. This is the special final payment referred to above.

Three main commercial issues are currently the subject of attention in the UK Islamic mortgage market. Clients are concerned about the level of deposit that they need to muster before being accepted by the bank. HSBC's new Islamic mortgage product to be launched at earliest in July 2003 in the UK may require as little as 10% (of the property price) in down payment by the client, but the Al Ahli murabahah and ijara schemes currently require a minimum 20% deposit from the client (reduced to 17% or less for larger property values), and the Ansar Finance diminishing partnership scheme requires a 20% deposit following the prequalification period. This level of minimum deposit does not compete with those interest based lenders who offer 100% mortgages, although Muslims who remember the experiences of the late 1980's property boom would probably not see this as a bad thing. On the other hand, following the announcement by Chancellor Gordon Brown in his recent Budget, the problem of double stamp duty (paid by the bank as purchaser from the original seller, and then again by the client as purchaser from the bank) is set to be neutralised. To achieve this, the two house sale transactions that occur in murabahah, for example, will probably come to be seen as part of one financing agreement operated in accordance with Islamic principles and not as two unrelated sales. Thirdly, bankers are concerned about the Basle capital adequacy standards in which a higher capital asset weighting is given to property assets than to property loans secured by mortgages. This requires a bank to devote more of its risk capital to Islamic mortgages than to interest based mortgage loans, and this in turn tends to increase the costs of Islamic mortgages when compared to their conventional counterparts.

The market for Islamic mortgages is substantial enough to provide a lucrative niche for those organisations that establish themselves early, but the retarded pace of development may have more to do with the attitudes of the Muslim community than lethargy on the part of mainstream lending institutions. I remember promoting a market-value based diminishing partnership model in 1995 to a Muslim Housing Association in London, only for the director to announce rather proudly at the end of my presentation that "We don't need Islamic finance. We have just agreed a five year fixed rate loan from Barclays Bank, thanks be to Allah". It was the "thanks be to Allah" bit that really depressed me.

For some, asking the Bank of England to organise a working committee on Islamic mortgages is like asking the local thief to install a security alarm. For others, an interest based mortgage is a price that has to be paid for living in a non-Muslim country. What seems clear at the moment is that many Islamic mortgage products have cash-flows and default conditions that are dangerously similar to their conventional counterparts. The Muslim community ignores this fact at its peril. Interest-bearing debt is the antithesis of true freedom and, like a heavily indebted country, a heavily indebted man is at the mercy of his lender and paymaster. People with big mortgages tend not to upset the boss on a point of principle. Likewise, the growth of an Islamic mortgage culture may be a powerful force for assimilating Muslims into the wider UK society. Is this the strategy being played out now?

The overriding political fact is that Islam provides the last serious institutional challenge to modern usury. Issues decided in the world of Islamic finance today may determine whether that challenge succeeds in years to come. At its worst, failure could mean that Islamic finance becomes just another way for conventional institutions to practice usury.



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The entire product range offered on this website is Shariah compliant. However, from time to time we will promote relevant none Halal products where no Islamic / Halal alternatives exist. Your home is at risk if you do not keep up monthly payments due under an Islamic / Halal mortgage agreement (your lease and / or diminishing ownership agreement).