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Thursday, 25 February 2016

Open the door to Islamic home finance

Discussions have been rife in the past whether Islamic home financing is “better” than a conventional mortgage to buy property. As with many financial matters, things depend on a variety of factors, in this case of course on market liquidity, financial soundness of the lending bank, availability of suitable financial products, types of property eligible for a mortgage, tax environment and legal framework, as well as pricing and fees.
Underlying assets
At first, the fundamental differences between Islamic and conventional mortgage need to be understood. The basic difference is the absence of interest in Islamic finance as it does not levy interest in any forms, but involves risk and profit sharing over an asset, in this case a property. The ethical component, apart from the absence or riba (interest) is that Islamic lenders do not solely look at earning profits but also grant loans “for the interest and growth of the community”, while conventional banks simply follow the principle of, as the saying goes, “money breeds money and loan breeds interest.” 
This means that, while borrowed money from an Islamic lender is always backed by an underlying asset, a conventional loan is just an entry on a conventional bank’s credit column, so-called “fiat money” created basically out of nothing and in case of a mortgage “secured” by the borrowers property which he already owns on the basis of the freshly created money. Islamic banks do actually buy the property and lease it out to their client until it is paid off with pre-agreed leasing rates that include a profit for the bank. 
Given that conventional lenders are driven to make money on compound interest, they often are not financially incentivised to prevent home owners from a foreclosure when they default on their payments. Islamic banks, in turn, are much less likely to pursue foreclosures as they own the property anyway, but tend to seek joint solutions with the borrower.
Overall, Islamic home loans can come in different types. "There are multiple options on offer including musharaka- [partnership] and ijara- [leasing] based contracts,” Ashar Nazim, Partner at Bahrain-based Global Islamic Banking Center of consultancy EY, tells GN Focus.
“Islamic banks are at par with their conventional counterparts in terms of products, flexibility and penetration. Since mortgages have a tangible underlying asset, they work well with Islamic financing,” he adds.
Profit rates
It is, however, often noticed that the profit rate for Islamic property finance is very similar to prevailing market interest rates for conventional finance. Some critics have noted that this would only show that Islamic mortgages are just “rebuilt” after conventional home loans and replace “interest” with “profit”. This is not correct at all as explained above, but the similar rates are inevitable in a competitive economy where money can flow between the two sectors. 
Having a lower price for “Islamic money” than the price for “conventional money” would distort the financial system and create arbitrage opportunities that would damage the entire finance sector. In fact, the Islamic finance industry has been working on developing products that can challenge conventional home loans not in terms of profit and interest rates, but in terms of product characteristics and flexibility – and, of course, the ethical aspect.
“Today, Islamic home finance solutions offer a level of product sophistication and depth of options which are on par with conventional financing options. Islamic finance covers the entire life cycle of customer needs, including purchase of ready or under-construction property, own construction of property, balance transfer from an existing facility with another bank, refinancing a fully-owned property, debt consolidation under property finance facilities, commercial property financing, financing home improvement and renovations, as well as land financing,” Gil Azevedo, Head of Consumer Banking at Emirates Islamic, explains to GN Focus.
In comparison to conventional options, Shariah-compliant home financing offers more protection to customers. For example, in the event the property is damaged due to a fire, providers of Islamic home financing are obliged to freeze the customer’s monthly installments since the property is deemed unusable and the customer ceases to benefit from the asset. Also, in conventional finance, in the event of a delay in paying installments, the customer is charged interest on unpaid interest. This is not permissible in Islamic financing,” he adds.
No uncertainty
Pawan Dhawan, Head of Home Finance at Noor Bank, points out another advantage. “There is no uncertainty [in Islamic finance contracts] and hence clients have peace of mind. For example, the profit amount or rate is clearly spelt out in the agreements and does not change unless both parties agree to amend it. This has proven rather advantageous especially for clients who had taken under-construction finance from the bank and even though the deliveries of the units were delayed, the profit amounts that they had to pay after years of delay were in line with what was agreed at the time of contract signing,” he says.
Noor Bank mostly enters Ijara agreements which involves sale of the usufruct, or benefit, of a ready or off-plan property but not the asset itself. This enables the client to use the asset without paying large amounts of money, does not transfer the ownershipof the asset but only transfers the right to benefits such as achieving rental income from it. At the end of the contract, ownership gets transferred. 
Other options such as “buyouts” and “equity release” are Shariah-compliant variant forms of this. However, it is important to note that Islamic finance also has some challenges. In practice, the arrangement of Islamic home finance is usually more expensive than conventional property finance, which has to do with Islamic banks normally lacking the economies of scale that allow conventional banks to reduce their non-interest costs such as staff and technology expenses. Islamic finance also typically includes more transactions than conventional finance to achieve the same goal, and has other costs such as expenses for the Shariah supervisory board.
EY’s Ashar Nazim also points out that “changes to an [Islamic] mortgage contract are usually expensive for customers compared to conventional banking. For example, if a customer wants to pay off the full mortgage during the financing period, or wants to get it refinanced through another bank, there are unnecessary penalties and costs involved. This is unsustainable and will need to change.”
Another issue is the paperwork involved which Nazim likens to a “cumbersome mortgage sign-up experience”. He cites the result of EY’s recent survey of UAE banking customers saying that “the process is still highly manual, inefficient and poor in terms of customer experience”, which, as a result, also drives up the intermediation cost for banks, which is then passed on to customers.
“Banks need to redesign the mortgage service or else they may lose market share to nimble, digitally-enabled financial institutions,” Nazim argues, adding that banks are also “failing to serve a big segment which consist of young and first-time home buyers. The UAE can learn from the UK in this space, where they have introduced the ‘Help to Buy’ scheme for first-time home buyers through a government incentive scheme”.
Strong growth
But this seems not to hold back customers in the UAE from applying for Islamic mortgages in growing numbers. For Emirates Islamic’s Azevedo, “Islamic home financing solutions in the UAE has witnessed a strong year-on-year growth". 
"A key indicator of this shift in customer interest is the growing market share of Islamic home financing providers of the total home financing market in 2015, which – as per our estimation – stands at approximately 50 per cent, and the penetration of Islamic home financing solutions is far in excess of the overall Islamic banking penetration in the UAE which currently stands at 21.4 per cent,” he says.

For Noor Bank’s Dhawan, growth potential is immense. “Shariah-compliant assets in the UAE crossed the $100 billion milestone for the first time in 2015. Islamic banking is growing at more than twice the rate as compared to conventional and is on track to achieve $263 billion of Shariah-compliant assets by 2019. This shows that the UAE expects a growth of more than 200 per cent in Islamic banking assets,” he notes.

(Personal Finance / 24 February 2016)
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