Confused between Islamic Home Finance V/S Conventional Mortgage Loans

By Sakshi Srivastava - 27 May 2021 Last Updated: 01 Dec 2021
Confused between Islamic Home Finance V/S Conventional Mortgage Loans

People can buy a house with cash or credit, but since not everyone can afford to pay cash, they can use banks as an option. These options include using Conventional banks' "mortgage loan" services or Islamic banks' "Islamic mortgage lending" services.

In a Conventional mortgage loan, you would be required to pay a rate of interest to the bank, which is their benefit for lending you the funds. Since it is prohibited to charge interest on a loan under Shariah Law, banks will buy the property on your behalf and rent or lease it back to you for a profit in an Islamic Home Finance. In this post, you will learn more about the differences between Conventional and Islamic home finance.

What is a Conventional Mortgage Loan?

A Conventional mortgage loan is one in which a financial institution, such as a bank, lends you money to buy a new home and charges interest on it. The principal sum (i.e., the amount borrowed) and the interest paid on the loan make up a Conventional mortgage loan. The principal and interest on most mortgages are paid off annually for a period of 25 years, which is why they are also known as repayment mortgages. The majority of a borrower's payments are directed toward paying off the interest in the early years, with a smaller portion directed toward lowering the principal. As the end of the term approaches, this process is switched, and more of the initial loan is paid off each month.

Repayment in Conventional

Most people get instalment mortgages when they get a Conventional mortgage. This is where you pay both the bank and the government every month:

  1. Interest, as well as a portion of the capital (i.e. the money you borrowed).
  2. This form of repayment is forbidden in Islam.

Ownership rights

You own the freehold of the property with a Conventional mortgage (i.e. you own the house). As a result, if you take out this form of loan, you are liable for any mishaps.

When a bank lends you money to buy a home, however, they place a "legal fee" on the land. This means that if the borrower defaults on the loan, the lender will be forced to sell the property in order to recoup the loan.

When you've paid off the loan, the legal fee is stripped from the property's title. This gives you complete ownership of the structure.

 

However, the bank's power will be limited if title defects or problems lower the property's market value, making it impossible for the lender to recover the money owed to it.

What is Islamic Home Finance, and how does it work?

Since Islamic financial institutions are prohibited from charging interest, Islamic home finance functions differently. There are many Islamic financing models, but the two most popular for home loans are Murabaha and Ijarah.

Return of funds

They are structured under Home Purchase Plans in an Islamic mortgage (HPP).

HPPs was divided into three categories:

  1. Ijara (lease),
  2. Diminishing Musharaka (partnership), and
  3. Murabaha (profit).

In summary, the Diminishing Musharaka plan is the most popular option for residential mortgages. The bank will own the majority of the house (e.g., 80%), and you will continue to pay rent, accumulating more equity, until you have 100% possession.

Lending money to benefit from any commercial or investment transaction, including the financing of real estate, is not an appropriate form of commerce according to Islamic legal jurisprudence. Guidance Residential's home financing programme is based on the Islamic financial principle of "Musharakah Mutanaqisa," or "Diminishing Partnership." In this approach, Guidance Residential and the homeowner form a partnership rather than a borrower-lender relationship. Natural disasters, eminent domain, and foreclosure are not risks shared by Conventional home loan providers. In the event of any of these misfortunes, the home buyer bears the brunt of the financial burden.

What is Murabaha financing, and how does it work?

Murabaha financing entails the bank purchasing a property on the customer's behalf and reselling it to them at a profit. After that, the buyer repays the bank in monthly instalments.

The property is registered to the bank before all mortgage payments are completed, but some banks may include the tenant's name on the title deed. Islamic banks need collateral to insure against the buyer not completing their repayments, so the property is registered to the bank until all mortgage payments are completed. A Shariah-compliant home loan has the benefit of not charging extra interest for late payments (though the bank may charge a fixed fee).

How does it work?

Murabaha is a form of halal mortgage contract in which both parties are aware of the cost of the goods to be sold as well as the profit on the deal. At the time of the contract assertion, the buy and selling costs, as well as the net sales, must be clearly stated. The Murabaha expense can be paid in full, in instalments, or in a single lump sum after a set period of time.

What is Ijarah financing, and how does it work?

Ijarah, which is a buy-and-lease-back scheme, is another Islamic finance model used. This model is advantageous if you are purchasing a home off-the-plan because no payments are made before the home is completed.

How does it work?

If you're looking for a Muslim mortgage, Ijarah is a good option. Here are a few of the laws and regulations to think about.

Muslim mortgage

Step 1: You locate a home to purchase and negotiate a fair price with a lender.

Step-2: As with any home loan, you and your Islamic moneylender agree on the loan amount. The property will then be purchased by your bank, both inside and out.

Step 3: You and the loan specialist then enter into two agreements:

  1. You can repay the property's purchase price in monthly instalments, usually over a period of more than 25 years (like an intriguing contract).
  2. You will pay a set amount of rent per month – this is for the benefit of the loan specialist.

Step 4: The lease is set every year, with annual abatements due to your slow payment of the property's price tag.

Step 5: After the loan specialist has been fully reimbursed, ownership of the property is finally transferred from the moneylender to you.

What are the distinctions between an Islamic home loan and a Conventional home loan?

The following are the key distinctions between the Conventional financial system and the Islamic financial system:

  1. First, interest is paid in the Conventional financial system, which is based on the demand and supply of money, while rent is charged in the Islamic financial system, which is based on the demand and supply of a real estate.
  2. Second, since Conventional banks do not own the underlying asset, they are not allowed to share the risk and reward associated with ownership, whereas Islamic banks are co-owners of the asset and share the risk and reward associated with ownership.
  3. Third, in Conventional banks, the return period begins on the date of the loan extension facility, while in Islamic Home Finance, it does not. The return is due under the Diminishing Musharakah model when the property is ready for use, either by acquisition or development.
  4. Fourth, even though the property is unusable and in need of repair, Conventional banks will continue to collect instalments (including interest and principal). You do not have to pay rent during the repair time if you use Islamic Home Finance.

Conclusion

Though Conventional banks regard money as merely a product, Islamic banks represent the public good and have as their primary goal the promotion of ‘halal' economic development. They just want to work with Sharia-compliant businesses. Islamic finance has progressed over time to become a viable alternative to Conventional home financing. The good news is that it is a cost-effective choice for those who want to buy a home without violating their religious values. As a result, if you're looking for a home loan, you can choose from both choices. Make sure you consider each one individually and then choose the best one for you based on your values and requirements.

By Sakshi Srivastava

27-May, 2021

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