Buying property can be a formidable process. Aside from the so-called fundamentals of looking for a home — dealing with a bank, arranging inspections and signing piles of paperwork — you also have to think about the long-term financial risks involved.
Will your house lose value? Will you end up underwater on the mortgage? Or could a financial crisis leave you unemployed and uncertain about the future?
It’s a lot to think about. But there is another option when buying a home in an era of repetitive financial insecurity.
How about an Islamic mortgage?
Islamic mortgages have risen in popularity over the last few decades as the number of Muslims in the U.S. continues to grow, a population expected to double to around 8 million by 2050, according to a 2017 Pew study.
But the mortgages are also available to people outside of the Muslim faith. The mortgages are available through specialized banks and some Wall Street institutions as well. The Islamic financial industry is worth about $2 trillion, according to a recent industry report.
Without treading into the complexities of theology and finance, an Islamic mortgage is basically one that does not charge interest, or riba, as it’s known under Islamic law. But before you get too excited, that doesn’t mean you’re getting a super cheap interest-free home.
“Overall, Islamic mortgages are a little more expensive than conventional mortgages just because of the transaction costs and the way it’s set up,” said Dr. Mohammad Kabir Hassan, a finance professor at the University of New Orleans and expert on Islamic finance. “The reason for that extra cost is the bank is also taking a risk, so it will charge a little more because they are also sharing in the investment and any losses, whereas a conventional bank won’t do that.”
The setup is unconventional and there are many ways that you and the bank can structure your arrangement to avoid interest. The most popular is known as diminishing musharakah.
The idea for the consumer is that they will slowly buy their house back from the Islamic lender over an agreed-upon period at an agreed-upon price without paying any interest and without any fluctuation in the price. That typically involves paying rent to the bank, which is then split into a rent portion and another portion that goes toward paying off the principal.
“If you make a down payment, let’s say 20%, the bank will pay 80%,” Dr. Hassan said. “The bank then rents the home back to you for, let’s say $1,000 per month. The bank is going to take 80% for rent, $800, and the remaining $200 goes toward paying off the principal. You keep paying $200 to the bank, buying back the bank’s principal, or $80,000.”
But, for home buyers who choose them, what’s really great about this style of mortgage is the bank also assumes losses on the value of your home.
For example, let’s say you own 20 percent of a house valued at $100,000 and the bank owns the other 80 percent. If the house suddenly loses 10 percent of its value, you only take on $2,000 of the losses whereas the bank assumes $8,000.
Traditional lenders won’t do that. There’s no concern about whether you’re making a good investment or paying too much for the property, or whether the value of homes in your neighborhood are trending down.
Crucially, that shared responsibility model may be good for young people, most of whom don’t have the savings to see themselves through a financial crisis. Millennials hold about 4% of all household wealth in the U.S., compared to the 54% held by Baby Boomers, according to a 2019 study.
Decades ago when real wages were higher and the cost of homes were relatively much lower, risk wasn’t such a huge concern. But over the last 20 years, there have been three substantial economic downturns, including the current one.
Those started with the dot-com bubble of the early 2000s, which destroyed around $6.2 trillion of household wealth, according to a FiveThirtyEight analysis.
About five years later, the Great Recession, which started with risky home lending practices, wiped away $6 trillion in collective home values throughout the country and left 11.7 million Americans underwater on their homes. In some places, property lost 30% of its value, leading to a foreclosure crisis.
An Islamic mortgage would absorb some of those losses, but there is more that can help mitigate against the overall risks of jumping into the property market.
“Islamic finance has numerous advantages, but the most obvious is that transactions are based on real assets and services, not just numbers in computers and thin air,” said Atif R. Khan, the managing director of the Ethica Institute for Islamic Finance, who referred to the computer generated credit scores as one of the primary ways traditional lenders decide to loan a customer money. “When an economy is tied to a real asset or service, economies are robust, communities flourish, and people are at peace.”
Atif is referring to how Islamic lenders decide to offer mortgages. Because the bank invests with you, it takes into consideration whether or not you’re making a shrewd investment.
“That’s one of the major benefits,” said Dr Hassan of the University of New Orleans. “You pay more but in return you have more oversight into your home and its expected future value.”
Because of the shared nature of the investment, Islamic lenders rarely make poor investments and go to great lengths to ensure the home you want is worth it.
Typically, Islamic lenders obtain three live-market estimates of how much homes rent for in the neighborhood where you hope to live. The customer also contributes three rental assessments to the calculation and a fair rental agreement is agreed for your house, according to Lariba, a California-based Islamic finance institution. That study of rental rates allows both parties to make a fair assessment of the neighborhood and catch any potential housing bubbles — the same ones traditional lenders missed in the lead up to the Great Recession.
A calculation is then made to work out the rent of return on investment. If the return on investment is good and more than expected by the lender and customer, the home is deemed to be a good investment and the lender will invest with you. If the financial model indicates that the investment is bad, the lender will explain that and decline to invest.
Of course, there are some exceptions. If you’re in the property market to make maximum profit and you’ve spotted what you think is a bargain, then the Islamic mortgage model may not be for you. And let’s not forget that interest rates are very low right now. But if you’re risk averse, an Islamic mortgage might be something worth looking into.
But the benefits don’t end there. Are you worried about foreclosure or losing your home?
“If the homeowner is unable to meet payments, some respite is given,” said Atif. “But eventually, depending on the Islamic financing agreement, he may have to sell the home on the market and take his share of the ownership. But the Islamic bank cannot repossess the home unless the borrower decides to sell it to the bank.”