Islamic Home Financing

Islamic Home Financing at a minimum involves 2 contracts that are usually an Ijarah Wa Iktana (Islamic leasing) and diminishing Musharakah (reducing partnership). This structure involves 2 steps:

1) An Individual and an Islamic Financial Institution enter into a Musharakah (Partnership) contract to buy a house, where the individual provides, let’s say 20% of the price of the house, and the Islamic Financial Institution  80%. The legal title of ownership is left to the Islamic Financial Institution, for the time being holding the individuals share in trust.

2) Then the Islamic Financial Institution enters into an Ijarah contract with the lessee, where the Islamic Financial Institution rents out its share (80%) of the house to the lessee. At this point the legal title of the house is still held by the Islamic Financial Institution; and the Individual gets an ownership of the usufruct (right to use) of the house.

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The individual pays monthly installments over the course of the agreed period. When the last payment was made by the Individual at the end of the agreed period of the house, meaning that the individual has paid the whole price of the house and is the 100% owner, the Islamic Financial Institution would sell the house for a nominal value (i.e. Kshs/USD/GBP  1) and, finally, gets the legal title of the ownership of the house.

The Lease is usually accompanied by a customer’s promise to purchase. During the lease, the customer has no ownership. There is no sharing. The actual development of the lease can be complicated by local laws as well as how the rental flow is structured.

NB: The diminishing Musharaka with Ijara wa Iktana are two relationships: co-ownership (which has several ways of being documented depending upon local laws); leasing (which also can have different approaches); with a promise to sell/purchase. Ijarah (Islamic leasing), allows a lessee (the individual) to take an ownership of the usufruct of a house. A lessee will pay periodic installments based on the Islamic Financial Institutions share of ownership.

PS: For a Financing for a House to be constructed Istisna’a contract can be used

Terminology Explained

Musharaka: – A form of partnership between the Islamic bank and its clients whereby each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of profits. However, losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise.

Ijarah and Ijarah Wa Iktana: – A lease agreement (similar to a hire purchase agreement) whereby instead of lending money and earning interest, the Islamic bank purchases the asset and rents it to the party requiring the asset and earns rental income. In ijarah wa iktana the renter agrees to buy the asset at a nominal price at the end of the contract. In ijarah (plain version) there is no such agreement to purchase the asset.

Istisna’a : – A contract whereby the purchaser asks the seller to manufacture a specifically defined product using the seller’s raw materials at a given price. The contractual agreement of Istisna’ has characteristic similar to that of Salam in that it provides for the sale of a product not available at the time of sale. It also has a characteristic similar to the ordinary sale in that the price may be paid on credit; however, unlike Salam, the price in the Istisna’ contract is not paid when the deal is concluded

Illustration.

Mohamed wished to purchase a KShs.22,000,000 house and he has Kshs 2,000,000 as down payment  and finances the balance of Kshs 20,000,000 from the Islamic Financial Institution over 20 years and bank sets a Kshs 1,000,000 annual rental rate for the Islamic Financial Institution’s share of rent. The rental could be bench-marked on market rentals ruling at the time and the Ijara wa Istana agreement providing for periodic revisions (3 or 5 years) based on market conditions. For the sake of simplicity, we’ll make it 20 annual repayments.

In the first column (see Table below) we have the year. In the second column we have Mohamed’s

equity purchase (his share), The third column Mohamed’s equity purchase amount, which is how much the he pays every each year for buying the property’s equity. In this way Mohamed increases his share of ownership in the property, while diminishing the Islamic Financial Institution share of ownership, shown in the fourth column. The fifth column shows the Rent, i.e. what the homebuyer pays the Islamic Financial Institution for that portion of the property he doesn’t as yet own. The sixth and final column shows what Mohamed pays in total every year.

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Table : Mohamed’s Diminishing Musharakah

 

Year Homebuyer’s Equity Kshs Homebuyer’s Equity Purchase Kshs Bank’s Ownership Kshs Rental Kshs Total Payment Kshs
Start 2015 2,000,000 2,000,000 20,000,000 2,000,000
2015 End 3,000,000 1,000,000 19,000,000 1,000,000 2,000,000
2016 4,000,000 1,000,000 18,000,000 950,000 1,950,000
2017 5,000,000 1,000,000 17,000,000 900,000 1,900,000
2018 6,000,000 1,000,000 16,000,000 850,000 1,850,000
2019 7,000,000 1,000,000 15,000,000 800,000 1,800,000
2020 8,000,000 1,000,000 14,000,000 750,000 1,750,000
2021 9,000,000 1,000,000 13,000,000 700,000 1,700,000
2022 10,000,000 1,000,000 12,000,000 650,000 1,650,000
2023 11,000,000 1,000,000 11,000,000 600,000 1,600,000
2024 12,000,000 1,000,000 10,000,000 550,000 1,550,000
2025 13,000,000 1,000,000 9,000,000 500,000 1,500,000
2026 14,000,000 1,000,000 8,000,000 450,000 1,450,000
2027 15,000,000 1,000,000 7,000,000 400,000 1,400,000
2028 16,000,000 1,000,000 6,000,000 350,000 1,350,000
2029 17,000,000 1,000,000 5,000,000 300,000 1,300,000
2030 18,000,000 1,000,000 4,000,000 250,000 1,250,000
2031 19,000,000 1,000,000 3,000,000 200,000 1,200,000
2032 20,000,000 1,000,000 2,000,000 150,000 1,150,000
2033 21,000,000 1,000,000 1,000,000 100,000 1,100,000
2034 22,000,000 1,000,000 0 50,000 1,050,000
Total 22,000,000

 

The homebuyer just pays for two things: the house, in installments and the rent, for the portion of the house he doesn’t yet own.

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