What are Islamic home loans and how do they work?

The Islamic faith carries a number of principles that influence how Muslims conduct their personal finances.

One area of personal finances that is affected is when it comes to borrowing money to purchase a home. Islam does not allow interest to be charged, and so traditional home loans are not suitable for Australians living by Islamic principles. Instead, specialised finance products are available.

To find out more, I spoke with the Chief Operating Officer at Hejaz Financial Services, Muzzammil Dhedhy. Below is our Q&A, with responses directly from Mr Dhedhy. 

How does the Islamic faith affect personal finances?

The laws of Islam govern every aspect of a Muslim’s life, including their financial activities. Islamic laws do not allow for Muslims to borrow on interest and as a result, Muslims are restricted in the market due to the prohibition of conventional banking products. Further, Islamic principles restrict the assets into which Muslims can invest, which means Muslims are excluded from various investment sectors and investment instruments. For example, Muslims are prohibited from investing in tobacco, alcohol, gambling, armaments, and conventional financial services such as banks that lend on interest or investment firms that invest in non-Islamically compliant investments. Similar prohibitions apply to financial products that can gain or lose substantial value, such as derivatives.  

What are the essential features of an Islamic home loan and what makes it halal or Sharia-compliant?

For a loan to be Sharia-compliant, it must adhere to the following requirements:

1. Monies used for loan funding must be obtained from compliant sources such as Islamic or ethical investment funds.
2. Loans may only be extended to borrowers engaging in Islamic-compliant activities. Examples of non-compliant or socially harmful activities include business operations such as casinos, breweries, or brothels.
3. Lending must be conducted using a unique contract which comprises both the requirements under Australia’s National Credit Code as well as the Islamic Ijara (shared equity rental) rules.
4. The transaction must be conducted in a fair, equitable and transparent manner between the financier and the customer.

How is an Islamic home loan different to a traditional home loan?

There are two key structures for an Islamic home finance product – Ijara and Murabaha. With Ijara financing (an Arabic word which means shared equity rental) the financier provides financing to the customer, enabling them to acquire and use the property, with the client then making repayments to the financier. 

The repayments comprise the Ijara rental component for the borrower’s use of the financier’s equity interest in the property, and a principal component whereby the borrower incrementally increases their equity in the property through repayment of the principal amount of the debt. This transaction occurs by way of a Finance Facility Agreement. To clarify, this model is not a rent-to-buy scheme. 

This differs from a traditional home loan, in which a lender extends credit to a borrower who repays the loan with interest.

Murabaha financing is a method of Islamic financing commonly found in the Middle East and the Asian subcontinent. It occurs by way of a contract where an Islamic financier, upon the request of a customer, purchases an asset from a vendor and resells it to the customer with an agreed profit margin. The customer then makes periodic payments of an agreed amount over a set period of time.

This method of Islamic financing differs from a traditional loan in that monies are not simply extended by the financier to the customer for the purchase of an asset, as is the case with a traditional loan. Rather, an asset is purchased by the financier and then sold to the customer. Moreover, under a traditional loan agreement, the final amount being repaid is unknown as there may be variability in the rate of repayment over the life of the loan, while under a Murabaha agreement the final repayment amount is pre-agreed between the parties, removing ambiguity and creating a higher degree of transparency.

What are some potential pros and cons of an Islamic home loan?

The salient benefit of an Islamic finance facility is that there is an ethical overlay applied to it, whereby both loan funding and loan purpose have an ethical requirement. Moreover, the mortgage products can be highly competitive with rates offered by many conventional non-bank lenders, and in some cases, may be cheaper than those offered by non-Islamic lenders. 

A limitation of Islamic financing is that there are some types of lending products which are not yet available in an Islamic form, such as SMSF lending. Muslim customers will also need to conduct further due diligence when looking for finance products to ensure they are compliant, which may limit their options.

Who currently provides Islamic home loans?

Various forms of Islamic home financing are offered by a handful of service providers in Australia. Those offering Islamic financing services comprise Australian Credit Licence (ACL) holders and authorised credit representatives (ACR) of ACL holders, operating as private companies or community co-operatives, most of which are suburban brokerages servicing subsets of their local communities.

What do you need to apply for an Islamic home loan?

The requirements to apply for Islamic home finance are similar to those of a traditional mortgage application. Essentially, applicants will need to substantiate their income in order to demonstrate their borrowing capacity, and provide proof of their intended deposit. The assessment process will consider credit history, employment details, dependents, expenses, liabilities, and property details. Notably, being of Islamic faith is not a requirement for this process.

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