How Does Islamic Home Financing Work?

Diminishing musharakah is a financing program based on declining partnership used for the purchase of homes, assets, or businesses. In diminishing musharakah home finance, the customer makes a down-payment and the bank finances the remaining amount through the sale of equity units to the customer. The customer purchases each equity unit over a scheduled period of payments and becomes the owner of the equity unit. The customer purchases each equity unit until all equity units have been purchased and the customer becomes the owner of the house in full and title is transferred from the bank to the customer. In this manner, the bank and customer are co-owners until the customer becomes the full owner of the property. At the same time, the customer moves into the house and in addition to purchasing equity units on an instalment basis, the customer also pays rent. The rental payments, however, decline according to the purchase of units in the equity unit purchase plan by the customer and the bank’s declining share of ownership in the house. As the customer purchases more equity units from the bank and becomes a larger owner in the house while the bank’s share in the house decreases, the customer subsequently pays a decreasing rental payment.

 

I illustrate this concept in a chart produced below based on a chart by Dr. Muhammad Hanif. Dr. Muhammad Hanif gives the example that a house valued at 1 Million USD Dollars is the subject-matter of a diminishing musharakah contract. Dr. Hanif explains that if the customer makes a down-payment of 20% or USD$200,000 dollars, the bank finances the remainder of the house at USD$800,000 dollars. The bank’s share in the house is divided into eight equity units to be sold over eight years at USD$100,000 each to the customer. The customer purchases each equity unit on an annual basis for eight years increasing his/her ownership of the house by a further 10% each year. Therefore, the customer pays USD$800,000 dollars to the bank in equity units for the eight equity units over eight years. In addition, as the customer has moved into the house upon joint-purchase, the customer pays rent to the bank for renting the bank’s share in the house. In year one, the customer pays 80,000 USD in rent or 10% of USD$800,000. In year two, the customer pays the bank $70,000 USD in rent according to the same formula, In year three, the customer pays the bank $60,000 USD in rent according to the same, In year four, the customer pays the bank $50,000 USD in rent according to the same formula, In year five, the customer pays the bank $40,000 USD in rent according to the same formula, In year six, the customer pays the bank $30,000 USD in rent according to the same formula, In year seven, the customer pays the bank $20,000 USD in rent according to the same formula, and in year eight, the customer pays the bank $10,000 USD in rent according to the same formula. The total that the customer pays to the bank in rent is $360,000 USD over eight years. In addition to paying the bank $800,000 USD for the eight equity units over eight years, the customer pays the bank $360,000 USD in rent over eight years. The rental payments decrease on an annual basis as the share of ownership in the house increases for the customer and decreases for the bank.

 

TABLE

 

According to Meezan Bank, this arrangement allows the bank to claim rent from the customer according to the bank’s proportionate share of ownership in the property and at the same time allows the bank periodical return of a part of the bank’s principal through purchase of the units of the bank’s share by the customer.

 An illustration of the main difference between diminishing musharakah in home finance and conventional mortgages is that if for some reason there is a default in Year 4 of the diminishing musharakah program, the bank will sell the house as co-owner with the customer, and if the house sells at the original estimated value, the customer shall get back $500,000 USD or the amount he/she paid in equity units and the bank shall take 500,000 USD or the value of the bank’s equity units in the house or in the same proportion. In a conventional mortgage, the bank would keep the entire sale price.

 

Steps in Detail (Meezan Bank) 

1.   Create a joint-ownership in the property (shirkat ul milk) between bank and customer;

2.   Bank leases bank’s share in the house to the customer and charges the customer rent.

3.   The client purchases units of the bank’s share in the house through an equity unit instalment purchase plan.

4.   There should be a one-sided promise from the client, firstly, to pay to the bank the agreed rent for the bank’s leased share in the house and secondly, to purchase the equity units of the bank according to the equity unit instalment purchase plan.

5.   The joint-purchase (sale and purchase) contract and the contract of lease may be joined in one document whereby the bank agrees to lease the bank’s share to the client after joint-purchase of the house. This is allowed because Ijarah can be affected for a future date. At the same time, the client may sign a one-sided promise to purchase the units of the share of the bank periodically and the bank may undertake that when the client purchases a unit of the bank’s share, the rent of the remaining units will be reduced accordingly.

6.   At the time of the purchase of each unit, sale must be affected by the exchange of offer and acceptance at that particular date.

7.   It will be preferable that the purchase of different units by the client is affected on the basis of the market value of the house as prevalent on the date of purchase of that unit, but it is also permissible that a particular price is agreed in the promise of purchase signed by the client. (In reality, the bank may have to book the purchase price at the outset of the contract)

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