How Are Islamic Mortgages Different to Conventional Ones?
What are the practical differences between Islamic mortgages to your standard High street one? In this article we discuss three crucial ones:
- Islamic mortgages are considered halal
- Interest is not involved; and
- Islamic mortgages involve ownership for the bank.
The fundamental difference is that according to some scholars (not all), an Islamic mortgage complies with Sharia law, whilst a conventional one does not. In other words, an Islamic mortgage is halal and a conventional one is haram.
Why? Interest. An Islamic mortgage avoids the borrower paying interest. This means the way you repay the bank is different under each type of loan.
Another difference is the way you own the property and risk profile after you take out your loan.
Rather than going into the ins and outs of halal/haram which you can read about here, we’re going to broadly look at the practical differences, in particular, repayment and ownership.
Let’s go into more detail…
Under a conventional mortgage, most people take out what is called repayment mortgages. This is where every month you pay the bank both:
- Interest, and
- Part of the capital (i.e. the money you borrowed).
This type of repayment is haram.
Under a conventional mortgage, you own the freehold of the property (i.e. you own the house). So, if you take out this type of loan, you’re responsible for anything that goes wrong.
However, when the bank loans you money to buy house, they take a ‘legal charge’ on the property. This means if the borrower defaults on the mortgage, the lender may ultimately need to exercise its power to sell the property to recover the loan.
The legal charge is removed from the title of the property once you have repaid the loan. This then makes the building all yours.
But… this power the bank has will be of limited value if defects or problems on the title reduce the market value of the property so that the lender is unable to recover the money owed to it.
Under an Islamic mortgage, they are structed under Home Purchase Plans (HPP).
There are three types of HPP’s:
- Ijara aka “rent-only” (lease),
- Diminishing Musharaka (partnership) and
- Murabaha (profit).
These three are explained in more detail in Ibrahim’s handy Islamic Mortgages Guide.
In summary, the most common method for residential mortgages are the Diminishing Musharaka plan. The bank will own most of the house (e.g. 80% of it) and you’ll continue to pay rent, buying further equity, until you have 100% ownership.
Another way of putting it is that the bank is holding 80% of a property on its accounts, rather than an £80k debt.
The key difference is that there is no interest paid on monies you borrow – it’s rent.
More context below.
The difference in ownership an Islamic mortgage has from a conventional one is designed in a way so that you avoid paying interest. It also affects your rights and responsibilities.
As mentioned above, the bank will own an equitable share and so will you. The bank will hold their share until you have paid them off for their share. After that, you’ll own the whole property.
It’s a partnership model where:
- The banks will take the freehold.
- (Unlike in a conventional mortgage where you take this)
- They then sell you a lease (for 99 years) just so you have some comfort that you can’t be evicted like any common tenant ordinarily could.
- This lease gives you an equitable interest in the freehold.
- This places restrictions on the bank’s control and limit their powers in dealing with the property or land.
- Once you pay the lease off, they will transfer the freehold to you.
This means this leasehold can only be sold or ended by the consent of the bank.
- Compare that to a conventional mortgage where you are free to do what you like with the property. Issues can arise If you need a lot of money fast, selling your house may not be an option under an Islamic mortgage – especially where the value of the house has fallen below the amount of the Islamic mortgage left.
If property loses value, the Islamic mortgage provider will not share the loss. Think of it from their point of view. You have signed up to a lease that you are obliged to pay. They want to sell it for the best price (e.g. not to sell during a recession/crash). For you to pay off the lease and their share of the property, a certain amount of money is required. You have an obligation to pay this off.
If you breach certain parts of your contract with the bank, they have the right to:
- Terminate the agreement with written notice; and/or
- Sell the property.
Furthermore, the bank is a named party on the insurance policy. Any damage or defect to the property is the bank’s responsibility (or at least its share of the property). If the building is destroyed and cannot be recovered by the insurance money or your own, the bank will be on the hook and your repayment obligation ends.
This is different to a conventional mortgage where you as the lender are technically still responsible for the repayment of your debt to the bank despite the house having been destroyed.
Some other differences
- Islamic banks are arguably safer than mainstream banks as they don’t engage in prohibited activities under the sharia, such as derivatives and exotic instruments trading.
- IFG has found that Islamic mortgages are almost always more expensive. You can see here that Al Rayan’s costs are higher than a mainstream bank. For Gatehouse bank, mainstream banks come out cheaper by around 25-30% – you can read more here.
- With an Islamic mortgage, buying and selling is sometimes a little harder.
- Firstly, the Islamic bank is a registered proprietor of the title of the house that you are buying or selling. This requires the bank to be a party to the deal.
- Secondly, many solicitors are not on the lender’s panel for banks that deal with Islamic mortgages. This makes it a little more complex for them to deal with. If your conveyancer/solicitor is on the lender’s panel, they can act for both the bank and the purchaser. This makes the process much smoother and bearable for everyone. It can also reduce costs.
Three key differences that an Islamic mortgage has with a conventional mortgage are:
- It is halal;
- there is no interest paid, and
- there is genuine ownership of the property by the Islamic bank.
You can compare the current Islamic mortgages available on the market using our market-leading comparison tool here.
Let us know your thoughts in the comments below.