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Islamic mortgages - who should gain / lose from property value changes?

Subject to local financial services regulation, the parties should be free to agree any terms they consider financially and religiously acceptable.

Posted 23 November 2020

I often receive questions about pages on my website, usually via the reader writing a public comment using the Disqus comments facility. (Readers can also email me via the "Contact me" page.)

As soon as I read a recent question, I realised that it would provide the basis for one of my monthly columns in the magazine "Islamic Finance News." My column was published on 4 November 2020.

You can read it below.

Muslims’ views on religious questions vary

When Muslims address religious questions by analysing the sources and then giving their opinion (i.e. write a “fatwa”), they traditionally conclude with the phrase “and Allah knows best.” That acknowledges God as the ultimate Arbiter of religious questions.

Despite that, I encounter many Muslims who believe that Islam has a monolithic set of rules.

Last month, my article “A simple introduction to Islamic mortgages” received a website comment about the future price when the Islamic financial institution (“IFI”) owning the property sells it in stages to the occupier, specifically asking about falls in value. The reader stated: “In my mind the “Owner” [the IFI] of the property has to bear this risk.”

There are many was of financing a property acquisition including:

  1. A fixed rate conventional loan.
  2. A floating rate conventional loan.
  3. A one-off murabaha transaction with the purchase price paid over a long period of time. This is economically equivalent to (1).
  4. A diminishing musharaka transaction, which can take several alternative forms:
    1. the rate of rent is fixed, and the dates and future prices of the property acquisition in stages by the occupier are also specified. Economically, this is equivalent to (1) and (3).
    2. The rent is periodically reset, with the future price being fixed. Economically, this is equivalent to (2).
    3. The rate of rent is periodically reset, with the future price being:
      1. Market value.
      2. The lower of cost or market value.

In 4(b)&(c), the reset could be:

  1. By reference to prevailing short-term property rental rates for transactions where the tenant acquires no rights of any kind to purchase the property.
  2. By reference to market interest rates.

In practice, (A) is never (or almost never) done. The reason is that comparing the economics of such a diminishing musharaka transaction with a conventional mortgage would then become much more complex for both financial institutions and their customers.

I have not attempted to exhaustively list all possible alternatives. Instead, I have focused only on those which I consider most relevant.

There are Muslims who consider every one of the above alternatives to be religiously permitted within Islam. Conversely, some Muslims will reject every alternative, at least where the rent is explicitly reset by reference to market interest rates, which is the norm.

Within diminishing musharaka, I regularly come across Muslims who consider that only scenario 4(c)(i) is religiously permitted.

My view is straightforward.

Religious freedom requires the state to stay out of religious questions, and to allow citizens to enter into the economic arrangements that they wish.

Accordingly, provided there is clear disclosure of the contractual terms, with deceptive advertising being prohibited, financial institutions and individuals should be free to structure mortgages as they wish. Obviously, it is important that financial institutions are adequately capitalised and take into account the economic risks of the contractual structures used, and also important that individuals are not misled.

In the United Kingdom, tax law was revised in 2006 to make diminishing musharaka mortgages possible. This was done by introducing a UK tax law concept called Diminishing Shared Ownership (“DSO”).

Qualifying DSO contracts exclude 4(c)(i) but permit 4(c)(ii). I cannot see any logical reason for this, except perhaps protecting consumers from agreeing to “give away” to the financial institution future price increases without understanding the financial implications of doing so.


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