How does Islamic home finance work? Understand the concepts of riba (interest), Murabaha (on transactions) and Ijarah (leasing agreement).

This is one of a series of six guides to Islamic products: Islamic Banking – how does it work? | Islamic bank accounts explained | Islamic credit cards explained | Islamic personal finance explained |  Islamic car finance explained | Islamic home finance explained. We also have a guide to Islamic finance for SMEs.

Why is Islamic home finance necessary?

According to Islamic law, banks are forbidden from making money by simply lending it. Therefore, a bank cannot earn interest, or riba, on money it loans to customers, and this naturally applies to home finance along with other financial products. In turn, it means customers do not pay any interest on the debt.

How do Islamic banks make home finance sharia-compliant and profitable?

Instead of lending a customer money to purchase a new home and charging interest on that loan, which is what happens in conventional banking, an Islamic home finance product might see the bank buy the property on behalf of the customer and then re-sell it to them at a profit. The buyer pays the bank back through monthly installments.

This is based on the concept of Murabaha, and helps the Islamic bank make the home finance without being seen to profit from the transaction. This is why it charges a profit rate on the loan rather than an interest rate as the customer pays for the profit through the fixed repayments.

Other Islamic concepts applied to mortgages include Ijarah, or leasing agreement, where the bank buys a property on behalf of the customer and then leases it back to them over a fixed period of time.

What happens if the customer misses a payment?

Because the bank cannot profit from the transaction, there should be no additional interest payments for late payment. While it may charge a fixed fee for the missed payment, in order to protect itself against repeated defaults, the bank needs strict collateral. This is why the property is registered to the bank from the start of the transaction until the loan is paid off.

It is important to remember that, like all home finance, Islamic home loans require a deposit and the new rules brought in by the recent UAE mortgage cap – a regulation that limits the amounts banks lend to customers buying a home – applies to the entire banking sector. Also, it’s worth noting that profit rates are as competitive for Islamic home finance as conventional mortgages.

Can customers switch from conventional to Islamic home finance even if they are not Muslim?

Of course. Islamic home finance products are open to all regardless of religion as long as you meet the bank’s approval criteria. Just remember to watch out for transfer fees when switching a home finance – these can be as high as five percent.

How do I find the best Islamic home finance?

By doing your homework. Compare all the Islamic home finance in the market to get an accurate understanding of factors such as the profit rates charged, the minimum salary required, whether it is a fixed or variable mortgage and also if there are any early settlement fees. [Compare Islamic home finance in the UAE | Compare Islamic home finance in Saudi Arabia]

Remember, in the UAE the  mortgage cap limits how much you can borrow from the banks with different caps set for expats and UAE nationals, as well as for second property purchases and off-plan properties. So make sure you have the right deposit to secure a sharia-compliant finance for the home of your dreams.