Islamic Mortgage 101- What do US Muslims need to know before buying a home?
Personal Islamic finance refers to how individuals give and receive money in accordance with the Sharia, or Islamic law. The pillars of this law are anchored around the avoidance of Riba (usury), the avoidance of Gharar (ambiguity or deception), and an even-handed risk-sharing between the transacting parties.
Islamic law views lending with a set and known compensation for the loan, which is the interest payment, as terms that favor the lender. Islamic law considers money as a measuring tool for value and not a value by itself. Therefore, it is Haram or prohibited, to receive income from money alone. This is called Riba and it is considered usurious and exploitative. By the same token, it is Haram to pay interest as the borrower. Hence, how are practicing US Muslims handling home buying, if we know that only 37% of US households are living without a mortgage, and even a good proportion of them had a mortgage that was paid off?
Moreover, to be Sharia-Compliant, risk-sharing is a second pillar to observe. Thus, financial institutions are required to share, with homeowners, the profit and loss of the mortgage business they operate in. The third pillar is the concept of Gharar, which refers to the ambiguity and deception that come from the sale of items whose existence is uncertain or events whose occurrence is unsure. Examples of Gharar would be some forms of insurance and derivatives used to hedge against possible outcomes. How do Islamic mortgage providers and Halal home buyers manage these requirements if in the US, homeowner insurance is mandatory, and mortgage-backed securities have become mainstream derivatives in the mortgage industry even after it was established that they were the main factors behind the great recession of 2008?
What are the Solutions to provide Islamic mortgages?
To be compliant with Sharia law, the problem of conventional mortgages can be solved by having the bank or the mortgage provider purchase the property and sell it back to the mortgagor or borrower in one of three ways:
1- The first is a sale with a markup through an installment plan: The bank will sell the property at a higher price to the homeowner under an installment plan, and have them pay a contribution toward the principal balance of the home each month until it is paid off in full.
2- The second method is known as the “lease-to-own” arrangement where the homeowner “rents” the property while paying down the principal and gaining home equity gradually. The rent price is typically established by looking at comparable homes in the area where the subject property is located. When an important amount of the house value has been paid down, the tenants and potential homeowners buy the property outright with cash.
As an example, if a home price is around $520,000 and the home buyer pays a 20% down payment, the mortgage will be around $350,000, if the mortgage cost is 4% for a 30-year duration, the monthly payments will be around $1,671. In the lease-to-own program, the homebuyer and the lender are co-owners of the house. The first monthly payment would contribute $504 toward the principal and $1,167 in rent to the lender. Like a conventional loan, the principal grows during the term of the loan, while the interest — or rent in the Islamic homebuying program — declines. The homebuyers build equity in the home and can use that money should they need to sell the house before the lease is paid off. Any equity from a sale belongs to the mortgage holder. If the home has declined in value at the time of sale, the owner and lender negotiate a payment from the homeowner to satisfy the loan. Tax breaks afforded to conventional homebuyers are also available to Islamic mortgage holders.
3- The third solution is to create a limited liability company (LLC) whereby the finance company and the home buyer co-own shares in the property and the percentage of that ownership changes over time as the payments are made by the homeowner to the finance company.
For the three solutions above to be done right, the Islamic finance company needs to effectively purchase the house, own it, and then transfer its ownership to the homebuyers. The transaction must be a trade, as opposed to money lending. The idea is that Islam does allow making a profit on a trade transaction or the sale of a commodity — in this case, the house.
Do you know that Fannie Mae and Freddie Mac invest in Islamic mortgages?
In the early 2000s, the US government-chartered mortgage financier Freddie Mac, that buys loans from banks and other lenders, has agreed to back loans financed for Islamic American buyers. This backing gave Sharia-compliant mortgage providers the flexibility and financial confidence in offering mortgage loans through these new methods. Because Islamic mortgages tend to be more straightforward than some of the exotic offerings seen in traditional Alt-A and subprime lending, default rates are lower than other mortgages. Fannie Mae followed Freddie’s suit and became an investor in Islamic mortgages as well, which they refer to as “no-interest financing,” allowing smaller banks and lenders to offer them to more customers. Smaller banks and mortgage lenders then started to offer more Islamic mortgages and then sell them to Fannie or Freddie, so they have funds to offer new mortgages to new customers.
How big is the Islamic mortgage market?
Even if the Islamic mortgage industry has made notable progress in the US in the last 20 years, it is still a market that is under-served and under-educated. Up until today, there are Muslim doctors and engineers who have been renting for years because they refuse to pay Riba, they do not have the amount needed to pay a home upfront, and they believe they do not have other choices.
Due to the beliefs above, many US Muslim families adopt stringent financial planning and savings regimen for years to pay their home upfront in cash. Other Muslim families make a compromise and purchase homes using conventional loans offered by most banks. However, many of them refinance as soon as they are informed about Islamic mortgages to leave behind the unease, they feel about their home funding choices. There are over 5 Million Muslims in the US and the mortgage industry for this market is estimated to tens of billions of dollars.
The number of companies serving the Islamic mortgage market has grown. The largest player is Guidance Residential, based in Reston, Virginia. Guidance Financial Group offers Sharia mortgage financing in 22 US states. Based on the company’s reports, it has processed $2.3 billion in Islamic home financing transactions between 2002 and 2010.
“We feel we’ve only scratched the surface with this niche market. There are still plenty of consumers out there of the Muslim faith that don’t even know this option is available” says Hussam Qutub, Senior VP of sales at Guidance Residential.
The second well-known name is American Finance House Lariba, headquartered in California and operating in 28 other states. Lariba is regulated by the Federal Reserve Bank of San Francisco, Los Angeles Branch, and the California State Department of Financial Institutions. In 2003, Yahia Abdul-Rahman, a former vice president, at Citigroup, transformed a local community bank into an Islamic bank. Since then, Lariba, which provides Islamic residential and commercial real estate financing, business, and trade finance. Today its customers include Muslims, Christians, and Jews. Other players in Islamic home financing are IjaraCDC and UIF. The Michigan-based Ijara Community Development Corporation (IjaraCDC) is a non-profit sharia structuring company and considers itself not a lender or a broker. Whereas, UIF offers home, commercial, and community center financing.
If you look at the big picture, sharia financing in the U.S. has accounted for less than $10 billion in home sales over the past 10 years according to published and dispersed data. This is an extremely small fraction of the sizable $33 Trillion U.S housing market. However, Islamic finance companies are making homeownership, paired with the peace of conscience, a reality, for more and more practicing Muslims.
Do you know that similar rules apply to the Jewish Faith?
There is a Jewish law, like Riba in Islamic law, that prohibits Jewish people from charging interest to other Jews. Recently, Quicken Loans, reportedly owned in majority by Jews, made a change in line with this law. Instead of considering the home loans the company makes as interest, they will now be known as a “co-investment” between the homeowner and the lender. This was big news because Quicken Loans and its subsidiary, Rocket Mortgage, are now the top mortgage lender in the United States.
This article was published originally in Aghaz Blogposts on 11/19/2020.
