For religious reasons, many British Muslims would prefer to avoid having a conventional mortgage. However when they investigate the cost of Islamic mortgages, (for details of how they work, see A simple introduction to Islamic mortgages) they are often dismayed by how much more they cost than conventional mortgages.
Most lenders offer a confusing variety of finance offers. However for a simple comparison, today I visited the website of Al Rayan Bank and looked up their rates for a 60% finance to value plan. This quoted the following costs:
In comparison, Nationwide Building Society for a first time buyer quoted the following costs:
Accordingly, while it has a lower fee, Al Rayan Bank's fixed rate is 89% higher (2.44% = 1.29% x 189%), nearly double, while the following variable rate is 13% higher.
I made this the subject of my March monthly column in the magazine Islamic Finance News.
I have been thinking about the relative prices of conventional mortgages and Islamic mortgages (for this purpose diminishing musharaka transactions) for residential real estate.
In the UK, Muslims who want to avoid taking out a conventional mortgage are often surprised to find that Shariah compliant Islamic mortgages are noticeably more expensive. As a result, Islamic mortgages tend to be taken out only by those Muslims who regard conventional mortgages as being religiously prohibited.
There are two relatively straightforward reasons why UK Islamic mortgages are more expensive than conventional ones.
Firstly, a conventional mortgage is a reasonably simple transaction to document legally.
The property is purchased and conveyed just once from the third-party seller to the new owner occupier, while the bank is protected by a registered fixed charge over the property. That fixed charge stops the new owner doing anything to sell or lease the property to a third party until he or she has paid off the bank’s mortgage loan. Repaying the mortgage simply involves the new owner sending money to the bank. Once the mortgage is fully paid off, the bank’s fixed charge over the property will be cancelled.
All of the legal paperwork used is extremely standardised and every UK solicitor who handles property purchases is familiar with it.
Conversely, a residential Islamic mortgage involves both the bank and the new owner occupier purchasing the property jointly. A lease is then required from the bank since the new owner will be a tenant of that part of the property which is owned by the bank. The way that the Islamic mortgage is reduced is that the new owner buys additional fractional shares of the property from the bank over the life of the mortgage. Even if there is no immediate conveyance of these additional fractions of the property from the bank to the owner, but only a memorandum record, at some stage (for example once the new owner has acquired 100%) the bank will have to transfer ownership of its share of the property to the new owner.
The contracts used are less standardised, and relatively few UK solicitors are familiar with them. Furthermore, there are simply more pieces of legal paperwork involved in an Islamic mortgage which adds to the legal cost compared with the legal costs of a conventional mortgage.
Secondly, and more significantly, the stand-alone Islamic banks in the UK are very small compared with the very large UK conventional banks. Indeed, the Islamic banks are dwarfed by many of the second-tier conventional banks in the UK. Many of the costs of running a bank (the need to have a compliance department, the need to have banking technology and backup arrangements) do not diminish proportionately as a bank becomes smaller in size. Consequently, such costs are a much greater burden for small banks than they are for large banks.
All these costs must ultimately be borne by the customers who take out Islamic mortgages and are reflected in the higher prices Islamic banks charge for Islamic mortgages.
In countries where Islamic banks are of comparable size to conventional banks, the second factor mentioned above should disappear. Greater prevalence of Islamic mortgages should also reduce the impact of the first factor, so the relative cost disadvantage of Islamic mortgages should diminish.
That raises the interesting question of whether Islamic mortgages can be cheaper than conventional mortgages. Insha’Allah I will consider that in a future letter.