Islamic Home Finaning – Case study based on KSA banks

by Maryam Hammad

1- Introduction:

 Most of people haven’t the financial affordability to build or purchase a house while only a few people own the resources that enable them to purchase their own house. So, they move towards the banks to request house mortgage for the long term repayment from their personal income.

 

2- What is home finance/mortgages?

 One of the most common forms of the debt is a home mortgage .Also, a home mortgage is one of the most advised. The consumer will has the lowest interest rate in a home mortgage loans than other type of debt.

 

 Home mortgages is a loan given by mortgage company , bank and other financial institution for residence purchasing or investment. The owner of the property ( borrower) transfers this property to the lender under the condition that the ownership of this property will be transferred back to the owner when the all payment has been made and after satisfying all terms and condition of home mortgage. 

 A home mortgage has fixed or floating interest rate and this rate is paid on monthly basis with a part of the amount of the loan principal. This interest will be decrease over time as paying down the principal by the owner.

 

3-Difference between Islamic finance and conventional finance:

·         Conventional Financing Principles

·         The essential part of the source of revenue in conventional institution is  the interest that charged on the money lending to the corporations and individuals. In addition, Interest is the main runner of conventional banks operations. Charging fee on international trade facilities, safety of wealth, guarantees and transfer of funds are other sources of income.

·         The Payment over a tenure  is made by installments in which  the part of  the payment of this installment goes towards servicing the interest and the remainder for down the principal.  Many facilities are provided by loan contract and it is known as a loan Facility agreement

·         Islamic Financing Principles

·         The system of Islamic finance operates according to the principle of Sharia and it promotes social justice.  Islamic finance concerns with moralities and values. so, immoral actions such as fraud, injustice gambling and ambiguity, are prohibited by Islam.  The transactions of interest-based (riba) are avoided by Islamic finance and it introduces the concept of buying something on the borrower’s behalf, and  then selling it back to the borrower at profit instead of interest-based transaction.  Profit and loss sharing in Islamic bank is based on Islamic mode of financing, Mudarabah and Musharka which is exclusive structured for Islamic institutions. Because Islamic institutions share the risk with the depositors, the risk in the Islamic institutions is lower than traditional institutions. 

 

4-Difference between Islamic home finance and conventional mortgages:

Conventional home financing is a common form around the world to purchase house where the customer signs a contract with the bank which contains schedule payment to be paid by the customer over specified period of time. The mortgage loans that provided by commercial banks offer this product for two groups of customer. The first is for commercial purpose and the second is for the residential purpose. The mortgage loan of commercial real estate is used for the purposes of business: building or purchasing shopping malls, restaurants and hotels and corporate offices while the residential loans are for general public usage to purchase or construct a house. 

Home financing according to Shariah-compliant is a financing a home form, in a way that the principles of Islamic law and its ruled do not violated. Also, the program of Islamic home financing does not involve  Riba (usury / interest), Maysir (gambling) and Gharar (speculation or contractual uncertainty).Generally, it is based on equity partnership between the bank and the customer  In Islamic home financing the customer pay monthly rent of the home purchased to the bank on the portion of funds supplied to purchase the home and this portion diminishes as the home purchaser pays to the bank to purchase the portion of the bank.  The wealth and income of conventional mortgage financing is not distributed equally and it create insecurity, stress and conflicts. In contrary, the shared equity financing which is in Islamic finance reduce the conflict, insecurity, and stress and make equitable society. 

 

5-Contracts used for Islamic home financing with process and details:

Islamic banks offer interest free products. The most common home financing products and structure are:

A- Murabaha or Bay’ Bithaman Ajil (BBA , deferred payment sale)

B- Diminishing Musharkah which is the most common product for home financing around the world

C- Parallel istisna (construction-required sale).

D- Ijarah (leasing).

 

A- Bay’ Bithaman Ajil Home Financing

 The Bay’ Bithaman Ajil ( commonly referred as ‘BBA”) home financing is based on deferred payment of shari’ah concept. It is a modification in the Murabaha (cost plus) contract, the product is received instantly while the price and the profit is paid in installments over long period of time.BBA term generally used in Malaysia and Brunei and it is known as bay mu’ajjal in the region of South Asia while in the middle eastern countries is known as bay murabaha. The facility of BBA is provided by Islamic bank to enable the home purchaser to pay the cost of financing. The bank purchases the assets  cash from vendor and sell is on credit basis to the customer. The selling price (The cost plus the profit) must be agreed upon concluding the contract between the customer and the bank. The bank is liable for liabilities and all defects until ownership is transferred to the customer.

The modus operandi of Bay’ Bithaman Ajil home financing:

1- The customer who want to purchase a house approach the bank for financing.

2- The bank  assesses the creditworthiness of the customer and approves the request.

3- The bank purchase the house from the developer and pay full amount on cash.

4- The bank sell the house to the customer at a markup price.

5- The customer pay the sales amount on an installment basis.

 

B- Diminishing Musharkah Home Financing 

 The diminishing Musharka (musharakah Mutanaqisa) is based on partnership equity. The customer and the bank (financer) create a contract to purchase a house jointly. The bank gives the option to the  customer (buyer) to purchase the portion of the bank in this house over the contract period. So, step by step the portion of the bank in this house will decline gradually till the end of the contract and the customer own the whole equity. This done by the customer who pays the schedule payment and monthly rent to buy the portion of the house that owned by bank. The rent that the customer pay is paid on the outstanding portion that owned by the bank. The contract can terminate at any point when the all remaining payment is paid by customer. 

The modus operandi of Diminishing Musharka home financing:

— 1- Musharaka contract is signed by both Islamic banks and customer in order to purchase the house. Jointly they will be the partners or owners of this house.  

— 2- At the beginning, the customer pay for example 20% as initial margin and the bank pay the remaining of 80%. 

— 3- The house will be rent to the customer after purchasing it, portion of the payment of the rent will go to the contract of Musharaka.

— 4- The ownership portion of the islamic bank will decline gradually from the payment of the rent.

— 5- The customer will have the full ownership of the house at the end of this contract.

C- Parallel Istisna Home Financing

 Istisna’ is an assets purchasing contract in which the purchaser place an order to purchase the assets that will deliver in the future according to the specification which is in contract. The purchase price, sale, and the installment will be decided by both parties. Parallel Istisna include two contract. The first contract is between the customer and the bank as a manufacturer, builder or supplier. The second contract between the bank as purchaser with a manufacturer, builder or supplier to meet the obligations of the first contract. The profit is realized from the difference of two contract.  

The modus operandi of Parallel Istisna Home Financing:

1- The customer request from the bank to construct a specified house (the specification include the type, nature, quantity, and the date of delivering). The price of the contract contain the cost to the bank plus the margin profit (e.g:250000). The customer will pay in deferred basis.

2- Islamic bank enter into another contract of parallel istisna’ contract with a subcontractor to develop the house (e.g;180000) as specified in the first istisna’ contract. The two istisna’ contract must remain independent .So, any problems arise of nonperformance of the one of the contracts should not  affect the other contract. 

3- The completed house will be delivered to the Islamic bank by the developer.

4- The Islamic bank will deliver the house to the customer and the installment must paid by the customer.  

D- Ijarah (leasing) Home Financing:

 Ijara is lease based contract used  by the Islamic banks under the principle of Ijara wa Iqtina,. The customer identifies a home and request the Islamic bank for financing. After analyzing the customer and the home by the bank, the bank purchases this  home and leases to the customer based on monthly schedule rent payment. Rizwanullah et al., (2012) argued that the customer contributes to the account to purchase the home  in addition of paying the rent. The bank will be responsible for all expenses that related  to this home. buyer equity of the home will increases with the payment. At the end of this contract the bank will transfer the  ownership of this home to the customer.

 

6- Islamic home financing instruments used by Saudi  banks ( example from Saudi Arabian banks and their products(:

Riyad Bank Islamic Home Financing :

 Riyad Bank provides financing of real estate host to its customers whose concern is to own a property. It provides to the customer all around the Kingdom of Saudi Arabia both a complete and incomplete property or a part of land and The mortgage advisors of Riyad Bank guide the customer to choose among this financing. The products of Riyad bank that based on islamic home financing are according to Shari’a compliant and are provided with competitive rates of profit margin and flexible payment plan. This products include:

·         Purchasing of Readymade Properties: Riyad Bank provides purchase of readymade property finance solutions and  providing the stability that its customers need. This product is provided with a high financing amount.

·         Purchasing Incomplete Property :Riyad Bank Home Financing assists the customer with purchase formalities and  it allows to pay regular installments based on the progress of construction with maximum finance amount.

·          Home Equity Readymade PropertyThe program of Riyad Bank’s Home Equity for readymade properties is offering to the customer with funds which support  in addressing the several needs of finance.

·         Home Equity Incomplete Property: Riyad Bank provides in this program for the customer the facility for making payments towards the completion of construction with financing up to SAR 5 million and terms of payment up to 240 month.

·         Land Finance: The Bank offers this product to support its customer to buy a land with various payment plans and maximum financing amount.

·         Subsidized Home Finance and Al-Moyassar Home Mortgage Programs: this is an innovative finance offered by Riyad Bank in cooperation with The programs of  Real Estate Development Fund and the Ministry of Housing in order to help the customer to own their dream house.

 

SABB Bank (The Saudi British Bank) Islamic Home Financing : 

 

·         SABB offers to its customer many options that enable them to own their dream house with the competitive rates of profit, high quality service for its customer and simple financing solutions. A wide range of products of Shariah compliant Home Finance are offered by SABB using:  The concept of Ijarah: SAAB buy property and leases this property to its customer. The financing period up to 25 years with a promise from the bank to transfer the ownership at the end of the period  to the customer. The lease rentals will be paid by the customer and the balance will be payable  to the bank over the period of financing in monthly installments. The properties that SAAB offers under the concept of Ijarah include: Completed villa, apartment or residential building, duplex, uncompleted house and land for building a home in future.

·         Istisna’a and Ijarah Mausoofa Fi-Dhimah: This is based on Construction + forward lease Structure concept and with the promise from the bank to  transfer the ownership to the customer at the end of the lease period. The period of flexible financing up to 25 years period , SAR 5 million financing amount and in which the bank is financing the customer who own the land to build his house. The value of the land will paid by the customer as a part of lease rentals in advance and the remaining balance is payable to SAAB over the period of financing in monthly installment basis. This product has quick approval and easy process.

The Saudi Investment Bank (SAIB) Islamic Home Financing

·          The Saudi investment bank is also provide Islamic home finance products.

·          ALASALAH Murabaha Home Finance: This is a product of an Islamic home financing that offered by the Saudi Investment Bank and this product is according to Shariah compliant and it is Murabaha based contract. The bank purchase the property based on the customer request and the process of evaluation. Then, the Saudi Investment Bank sells this property to the customer based on monthly payments for specified and a greed period of time. The time period can be from 5 years to 25 years with financing amount up to SAR 5 million.  At the end of the period and when the all installment are paid by the customer, the bank transfers the ownership of the property to the customer. Al ASALAH home finance is available for apartments, villas, land and the rate of profit is fixed over the financing period.

 

Al Rajhi Bnk Islamic Home Financing

Al Rajhi Bnk provides many solution for its customer who want to own a house, villa or apartment by purchasing or building. Also, it is providing opportunity to  purchasing a piece of land. Moreover, Al Rajhi Bnk helps the customer in purchasing an investment property and collecting the from the rent. The solutions that the bank provides based on Islamic home financing are:

·         Buy a home: this is for the customer who want to buy ready villa or apartment with finance period up to 20 or 30 years.

·         Buy a Land: this type for the customer who want to buy a land to build his house with finance period up to 20 years.

·         Real Estate Development Fund (REDF) additional finance: This is a program of  real estate financing that based on  the principle of Murabaha and it offers for the customer that satisfied the credit conditions of Al Rajhi Bank. The property  will be purchased  by Al Rajhi Bank on behalf of the customer based on full amount payment  to the seller on the basis that the development fund on behalf of the customer will pay an amount of 500 thousand Riyals towards the bank as an advance payment of the purchase amount. 

·         Home and More: here the bank provides in one package both home and personal at the same time.

·         National Commercial Bank (NCB) Islamic Home Financing: 

·         NCB provides Islamic home finance compatible with the provisions of sharia’ on the basis of Murabaha and Ijara. The bank require 30% down payment for this home finance  and the amount of finance up to 3 SAR million for payroll customers and 7 million for affluent customers with the possibility of early settlement and SAR 3000 is the minimum required  salary.

 

 

7- Case study – (Products, how do the bank calculates the rates and rentals, risk management, agreement, calculations based on Islamic bank):

In Al Rajhi Bank and under Islamic home financing the bank provides services of Home and More in which the bank provides in one package both home and personal at the same time. In the case of monthly salary is SR 10,000  the customer can get the following finances a according to Al Rajhi Bank terms and condition:

 

Personal  Home

Finance Amount (SR) 183,468 Finance Amount (SR)

888,451

Term Cost % 3.50% * Finance Rate % 2.95% *

Annual Percentage Rate (APR) % 4.01% * Effective Rate % 5.05% *

Finance Period (Years) 5 Finance Period (Years)

Total Monthly Installment (SR) 6,000

Number of Installments ( Months) 240

* source: Al Rajhi Bank.

 

·         Parallel Istsina’ home financing case study of one of  Malaysia Islamic bank:

·         The customer identifies a house to purchase and approach the bank for  financing. Then, the customer and the bank will agrees on financing using alistisna’. The bank will enter on parallel al-istisna’ contract with housing  developer to deliver the house as specified in the first istisna’ contract for say SAR 500,000 and now the bank is the owner of this house. After that , the customer will pays as agreed payment schedule over the period of  al-istisna’.

·         For Example; If the purchase price of  the house is SAR 600,000, profit rate is 10% and the customer down payment is 10% (SAR 60000). A financing tenure is 30 years and the installment will be paid on monthly basis. The bank enter parallel istisna’ with the developer which cost 530000 .The computation is as below;

– Annual installments = i((1+i)^n)PV/((1+i)^n)-1

 

= .10 ((1+.10)^30)(600000-60000)/ ((1+.10)^30)-1

 

=SAR 52,282.87

 

– Monthly installments= Annual installments/12 months

 

= 52,282.8/12 

 

= SAR 4,356.90 per month

 

=4,356.90 x 30 years x 12 months

 

= SAR 1,568,486.10

 

   So, the total payment is SAR 1,568,486.10 and SAR 4,356.90 is the monthly payment for the period of 30 years.

 

The risk management of Parallel Istsina’ home financing

 

– Credit risk Management:  1- the probability of  the expected loses and default are assessed carefully by the bank. 

 

2- Generally , band al-Jazaa ( penalty clause) frequently used by bank to ensure that the manufacturer are produce or construct as specification in the contract.

 

3- The delivery of the fund can be agreed on the different phases of the construction. So, the payments will be aligned with milestones.

 

– Market risk Management:

1- The property or the commodity is sold before the date of delivery through parallel Istisna’. by bank.

2-Basid on the different scenarios of market the future market price will be valued.  

3- VAR analysis was used to the market risk management and to the future market price evaluation.

– Liquidity risk Management:

1- Several quantitative models are used by the bank to identify the risk and the price of its product will determine according to that risk.

– Operational risk Management: 

1- The bank ensure that there was not any misappropriation in the distributed fund by ensure that the payment to the supplier with the inspection and ensure the property take place.

2- Ensure that appropriate quality is followed by the manufacturer by taken guarantees from the manufacture.

   

8- Conclusion:

 The system of Islamic finance operates according to the principle of sharia and it is promote social justice. Also, Islamic finance concerns with moralities and values. Islamic bank offer  for its customer many options that enable them to own their dream house with the competitive rates of profit, high quality service for its customer and simple financing solutions. A wide range of products of Shariah compliant Home finance are offered by several Islamic bank.

 Islamic home financing products is more beneficial for the customer than conventional home financing. Also, because Islamic institutions share the risk with the depositors, the risk in the Islamic institutions is lower than traditional institutions.

 

9-  References:

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3. Alrajhibank. (n.d.). Retrieved May 08, 2017, from http://www.alrajhibank.com.sa/en/personal/home-finance/pages/default.aspx

4. Asian Institute of Finance. (2013). Risk Management In Islamic Banks

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9. Ibrahim, M., & Kamarudin, R. (2014). THE ISLAMIC HOME FINANCING IN MALAYSIA ISTISNA’ BASE ON DEBT: QUALITATIVE APPROACH. Labuan e-Journal of Muamalat and Society,,8.

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