The UK is one of the key centres for Islamic finance outside of the Middle East and Asia, with six fully shariah compliant banks and 20 institutions that offer shariah compliant products. The UK is considered the leading Western centre for Islamic finance.
Islamic Finance is a term that includes a wide range of financial products and services, they often resemble conventional products. The purpose is the same, however, Islamic Finance is designed to be compatible with the laws of Islam whilst obeying the laws of the country in which they are offered.
Islamic Finance is based on Islamic or Shariah law, which is then applied to real world financial world transactions and applications. It is reported that Islamic banking assets in the UK grew at a compound annual rate of around 10% between 2016 and 2021. In the first quarter of 2023, UK-based Islamic funds had assets of approx. 280 million dollars.
A Sharia-compliant mortgage, also known as an Islamic Mortgage, allows people to buy a home without paying interest. The principle of interest free (Riba free) is the idea that contracts, transactions and practices should be free of interest. Islamic mortgages are regulated by the Financial Conduct Authority and are based on lease agreements. The framework for shariah-compliant mortgages in connection with residential properties can also be considered in the Land Registry Practice Guide 69.
What is the framework?
The term shariah-compliant mortgage is a term interchangeably used with ‘Islamic Mortgage’. This type of mortgage is not just exclusive to Muslims in the UK, they are also available to non-Muslims. The main factor is that interest is not accounted for when making a repayment.
Land Registry Practice Guide 69 summarises the theory behind an Islamic Mortgage as follows:
The theological basis for Islamic finance stems partly from the traditional prohibition of usury or interest, which means that interest-based lending may not appeal to followers of Islam. Islamic finance products have been structured to avoid the payment of interest. These financial products have been developed so that they fall within the regulatory and legal framework of England and Wales and so introduce no new concept in HM Land Registry terms. They are available in the UK to Muslims and non-Muslims alike.
There are three forms of Islamic Finance models for residential home purchases:
• Murabaha
• Ijarah
• Diminishing Musharakah
Murabaha Model
Under the Murabaha model, the Islamic Bank will purchase a property on a consumer’s behalf, and then they will sell the same property at a marked up price.
For the purpose of illustration, a consumer will go to an Islamic bank and will request a mortgage for a property, let's say worth £100,000. The Islamic bank agrees to facilitate this purchase on behalf of the consumer whereby the bank now owns the property. Subsequent to the purchase from the bank, the bank then sells the property to the consumer for £125,000, payable over 20 years and the consumer now owns the property (subject to keeping up with their payments). The bank sells the property to the consumer at an agreed profit margin over the cost, thus, the Murabaha model is not a loan given on interest, it is a sale of a commodity for money.
The consumer under this model will pay the price of the property in instalments over several years. The instalments will be paid whilst mortgaging the property to the bank in order to secure instalments that are due.
A simple Murabaha arrangement for home finance is shown here: Murabaha arrangement.png
Ijarah Model
This option is by far the most popular and affordable for most consumers in the UK. Under the Ijarah model, it is a ‘lease-to-own’ agreement, so in simple terms, with an Ijara plan, the Islamic bank purchases the property the consumer wants outright.
Following the purchase by the bank, the consumer makes monthly payments that cover the purchase price of the property, rent and any other charges. The monthly ‘mortgage’ payments are fixed annually in such a manner that the bank gets back its principal sum along with some profit. At the end of the term, the consumer will have repaid the full amount of the property and own the property outright, thereby terminating the lease arrangement.
The ’lease to own’ model (Ijarh mortgage model) works like this:
• Consumer finds a house to purchase and agree on a sale price with the seller.
• Consumer agrees to the amount of the mortgage with their Islamic bank who will purchase the property outright.
• Consumer enters into two agreements with the lender:
o The first is that they will pay back the purchase price of the property in fixed monthly instalments, usually over 25 years.
o The second is that the consumer agrees to pay the lender an agreed amount of rent each month.
• The rent is set annually, and decreases each year in line with their gradual repayment of the purchase price of the property.
• When the purchase price has been fully repaid to the lender, ownership of the property is transferred from the lender to the consumer.
The lease will usually be long enough to require registration under the Land Registration Act 2002. When the lease ends, the consumer will submit a Land Registry transfer of the reversion back to the consumer.
Diminishing Musharakah Model
This model primarily applies the principles of co-ownership, and is generally structured in a way that the Islamic bank contributes towards the purchase price of a property as a co-owner, rather than as a lender.
Musharaka means ‘partnership’ and is used for home purchase financing. Typically, a consumer would like to purchase a house, however, due to not having sufficient funds, the Islamic bank agrees to fund a certain percentage of the purchase price.
The following scenario illustrates how this model is typically implemented:
• Bank to pay 80% of the purchase price, the remaining 20% is paid by the consumer.
• The framework under this model will mean the bank will possess the legal title of the property on completion of a purchase, and a lease is created between the bank and the consumer.
• As the bank and the consumer are now co-owners, a separate diminishing partnership contract is entered into between the two parties to split the beneficial interest in the property.
• Using a 80-20 split, the bank will be entitled to 80% of the beneficial interest and the consumer will be entitled to the other 20% beneficial interest.
• After the lease is created, the consumer will pay rent to the bank for using its 80% share in the property.
• In addition to the rental payment, over time the consumer buys the bank’s beneficial interest in the property and eventually becomes the owner of the bank’s 80% share. The bank will give an undertaking to the consumer at the outset to transfer back the property at the end of the lease term.
A simple diagram for a Diminishing Musharaka mortgage is shown here: Diminishing Musharaka mortgage.png
Final thoughts
The Islamic banking sector in the UK is continuously growing, however, there are still challenges and some critics argue that the banks operate in a niche market and struggle to ensure competitive rates are provided.
A common criticism of Islamic mortgages is that they tend to be much more expensive than a conventual mortgage when, ethically, it should not be more costly to be sharia compliant.
Another argument against Islamic mortgages, is that the consumer have to pass strict criteria in order to be granted the mortgage.
The downsides should be off-set if competition continues in the Islamic banking sector in the forthcoming years. There has been an increase in consumers taking out Islamic mortgages. If this trend continues, there may be better rates and more flexible affordability criteria for consumers in the future.
Further information
Should you require any additional information regarding sharia complaint mortgages or residential or commercial property, please do not hesitate to contact Mr Syed Hoque on e: syed.hoque@lawcomm.co.uk or Mr Bill Dhariwal on E: bill.dhariwal@lawcomm.co.uk
The contents of this guide do not constitute legal advice.
