Islamic Mortgages: The Shariah compliant way to buy in 2023
If you're looking for a Shariah compliant ways to buy a home, check out our introduction to Islamic mortgages, how they work and the best alternative.
When it comes to getting a mortgage, sometimes the considerations are more than just financial. For many, price, legal considerations and the current state of the market aren't the main focus. But, cultural and religious are.
Islamic law only permits interest free loans, which means that Muslims often can’t get a traditional mortgage. It also means government schemes like Help to Buy and Shared Ownership generally don't work for Muslims.
However, what if Muslims (or other customers who want to follow Shariah law) don't want to rent for the rest of their lives? That's where Islamic mortgages come in.
An Islamic mortgage is designed for those who want to buy a house, but want to go down a halal route when applying for a mortgage. Islamic mortgages are also referred to as Shariah compliant mortgages, or halal mortgages.
In the UK, there are a range of Islamic mortgages available on the market, allowing a customer to apply for a mortgage, whilst staying halal.
We're going to take you through the basics of Islamic mortgages, the different types, how to apply for one, what the potential risks could be and where you can apply for an Islamic mortgage. Let's dive in.
Feel free to jump around:
- What is an Islamic mortgage?
- Why choose an Islamic mortgage?
- How does an Islamic mortgage work?
- Types of Islamic mortgages
- Are there any disadvantages to Islamic mortgages?
- How we could help you buy a home in a Shariah compliant way
What is an Islamic mortgage?
An Islamic mortgage is a type of mortgage that bears no financial interest. They work as a no-interest home purchase plan, which is also referred to as 'HPP'. This means that Muslims can apply for a legal mortgage without going against their beliefs.
The HPP will help you towards buying a property. You'll essentially be in partnership with the Islamic bank or Shariah compliant provider, paying rent on a monthly basis.
Each rent payment will increase your ownership share of the property, and reduce the bank's financial share. In other words, the Islamic bank replaces the “interest” component with “rent”.
Why choose an Islamic mortgage?
The biggest difference with an Islamic mortgage, is the fact that you don't have to pay any interest.
It's against Shariah law to apply for a loan with interest. This comes from the fundamental belief in Islamic finance, that money shouldn’t have any value in itself. It’s just a way to exchange products and services that do have a value.
Because paying interest is the concept of making money from money, it goes against Islamic finance beliefs. Therefore, because conventional mortgages are interest-bearing loans, Muslims will often aim to avoid these types of mortgages.
Islamic finance also encourages partnership. This could be partnership between people, businesses, or both.
Because both the buyer and the lender buy a share of the property, this ties in well with Islamic finance beliefs, making it halal. This means a customer can apply for a mortgage, without sacrificing those beliefs.
How does an Islamic mortgage work?
You'll need to work with a bank that offers products and services in compliance with Islamic finance laws. The bank buys the property on your behalf, which means they become the legal owner of that property. You'll then have to make monthly payments to the bank.
In this way, your monthly payments are much like rent payments, with a portion going towards buying out the property owner’s stake.
The rental rate of an Islamic mortgage will be shown as a percentage, which changes depending on the Bank of England base rate.
At the end of the fixed term, you should have either made enough payments to the bank to have bought the property back, making you the legal owner. Or, you have an outstanding fee that you'll need to pay before you own the property.
Types of Islamic mortgages
There are three main types of halal mortgages: Ijarah, Diminishing Musharaka and Murabaha. Let's take a deeper look into the three main types of these home purchase plans.
Ijarah
Ijarah can also be referred to as a 'rent only' mortgage.
When a customer buys the property, they'll put down a deposit, while the Shariah compliant lender contributes the rest.
With an Ijarah mortgage, you'll make monthly rental repayments on the bank's share of the house over a fixed term. However, you don't have to make any payments towards buying the bank's share of the property.
If you decide to go for an Ijarah home purchase plan, you need to make monthly payments that are part rent and part capital. These payments contribute to your final home purchase.
This type of Islamic mortgage is more often used in a buy to let context, rather than buying your own home to live in.
For example, if you're aiming to generate more cash flow, rather than owning the whole property, you might choose to go with an Ijarah mortgage.
This is because you may have to end up selling the property at the end of the term, if you still haven't paid back the bank's complete contribution.
Diminishing Musharaka
Diminishing Musharaka is the most common HPP structure that lenders offer in the UK.
Diminishing Musharaka home purchase plans refers to a joint purchase and ownership agreement between you and your Islamic bank. In this case, you'll pay your Islamic bank's share in monthly repayments.
This means that as your ownership share grows, theirs will shrink. When you initially buy the property, you'll have to put a deposit down.
To avoid high rent costs, it's better to put down as a high a deposit as you can, at least 20% depending on what the minimum requirements are.
Murabaha
The Murabaha is another type of interest free home purchase plan. Your Islamic bank or Shariah compliant provider buys the property, and then will sell the property to you at a higher price.
For example, if you're looking to buy a property for £100,000, the bank may sell the property to you for £150,000. This can then be paid for in monthly instalments over a fixed term.
In the UK, a Murabaha mortgage is more often seen for commercial properties, development financing and bridge financing situations, rather than residential home purchases.
In the Middle and Far East, however, a Murabaha mortgage is viewed by Muslims as more compliant in terms of Shariah law, so it's much more common for residential properties in those parts of the world to go with a Murabaha mortgage.
What qualifies you for an Islamic mortgage?
To be able to apply for a Shariah compliant mortgage, you'll usually need to pay a deposit to the bank of at least 20% of the property.
As well as a deposit, you'll also need to budget money in for things such as surveys, building insurance, stamp duty and any other costs, such as mortgage broker fees and legal costs.
Make sure you factor in those extra costs, so that you're able to keep up with your payments until the end of the term.
Can anyone apply for an Islamic mortgage?
Short answer? Yes. If you prefer the ethics behind Islamic finance, and would rather go for loans that are interest free, then the halal route might be the one for you.
An Islamic mortgage is seen as ethical because you know the full cost of the loan from the get go—there is no interest rate.
Furthermore, the money raised by 'ethical' lenders is not reinvested in industries that are not supported by Islamic beliefs. Such as alcohol or gambling.
Islamic mortgage calculator
Using an Islamic mortgage calculator will help to give you an idea of what the rate of your monthly payments might be, much like a mortgage calculator for conventional mortgages.
To get an accurate estimate of what you'll need to pay, you'll have to enter the finance amount, the product type, and the finance period.
How do you know that banks are Shariah compliant if it's not an Islamic bank?
Providers that offer Islamic mortgages should be able to provide evidence that shows they've had Shariah compliance guidance, specifically from an authority in Islamic law.
Are there any disadvantages to Islamic mortgages?
Higher cost
Applying for an Islamic mortgage can sometimes cost more than other types of mortgages on the market. This tends to be because the bank or lender has to pay higher administration costs.
Even though the Islamic bank or Shariah compliant provider is the legal owner of the property, you'll be responsible for other costs.
These could include the cost of conveyancing, general maintenance, and Stamp Duty. Make sure that you add these costs when you initially budget the cost of your house purchase.
Higher deposit
You may also have to pay a higher deposit. You can apply to some other types of mortgages with a deposit as low as 5%.
However, you may have to provide a deposit of 20% or more if you decide to go with an Islamic mortgage. If you cannot afford that amount, you might run into problems very early on.
Early repayments can be more expensive
If you, as the customer, want to sell the property to another party, you'll need to repay the Islamic bank.
For example, if the original fixed term is 10 years, and you want to sell the property after 3 years, you'll need to make an early repayment to the Islamic bank. This early repayment is likely to be a much higher price than a different type of mortgage.
A way to solve this problem would be for the bank to recompute the transaction to allow a discount for early payment. However, this system would need to be evaluated to see how it complies with Shariah law.
What are the risks of an Islamic mortgage?
As with any product that involves a loan, there are sometimes some potential risks associated with Islamic mortgages.
Fines
If you're late on your mortgage repayment, or you miss the deadline, you'll most likely be fined. If you keep failing to repay these payments, your home may be repossessed.
Always make sure you check fine and repossession terms before you take out an Islamic mortgage, and understand the penalties for failing to keep up with your payments.
Rental rate
A lot of Islamic mortgage providers use LIBOR-pegged rental rates, as opposed to the average rental rate in your local area.
While this could work in your favour, it may also mean you end up spending more money more than you initially expected.
Islamic mortgages vs conventional mortgages
Islamic mortgages don't pose more risk than a conventional mortgage. As we mentioned earlier, Islamic banks are fully regulated by the Financial Conduct Authority and the Prudential Regulatory Authority. They have a strict line of conduct to follow, so as a customer you're legally protected.
Additionally, the Financial Services Compensation Scheme (“FSCS) applies to Islamic banks as well. So £85,000 of your money in a savings/current account with an Islamic bank will be secured by the FSCS in case the bank collapses.
In some ways, Islamic banks might be safer than mainstream banks. This is because activities that pose a risk, such as derivatives and exotic instruments trading, are forbidden under Islamic law, which means the banks don't engage in these activities.
Because of this, a lot of non-Muslims actually use Islamic banks. They're looking to take advantage of the market-leading savings rates offered by such Islamic banks or take out a HPP where there is no penalty for early repayment.
Which banks offer Islamic mortgages?
There are a few Islamic banks in the UK that will offer you Islamic mortgage services and products, including buying the property on your behalf and home purchase plans.
Gatehouse Bank
Established in London in 2007, Gatehouse Bank is one of the biggest banks that follows the principles of Islamic finance. It's authorised by the Prudential Regulation Authority (PRA) and regulated by the Financial Conduct Authority (FCA) and the PRA.
United Bank Limited (UBL UK)
UBL UK is another huge bank that operates under Islamic finance rules. It's also market regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
It was formed in 2001, following a merger of the UK branches of United Bank Limited and National Bank of Pakistan.
Banks that are Shariah compliant
You can apply for an Islamic mortgage at plenty of other UK banks and building societies. These halal mortgage alternatives still follow Islamic law; the banks just don't refer to themselves as Islamic banks specifically.
Al Ahli
Ahli's products usually tailor to those looking to buy more expensive properties, often located in London.
Heylo Housing
Heylo Housing offers a mortgage alternative. It's a shared ownership agreement between the buyer and the lender. The buyer can then buy back as much or as little of the property as they so wish.
When it comes to Shariah compliance, it's a possible alternative. With Heylo Housing, you don't have to buy the bank's share of the house, which means there's even less of a debt paying element to this route.
Other UK banks and societies
The opportunity to apply for an Islamic mortgage isn't limited to these providers, so it's always worth doing your research to see which bank can offer the best Islamic mortgage product for you.
Or get in touch with an expert mortgage broker that can offer you the advice you need to ensure you get the best deal.
It's important to note that Islamic mortgages and home purchase plans are regulated by the Financial Conduct Authority. This means that your provider, whether it's a bank, society, or other lender, are legally required to protect your interests.
Someone who applies for an Islamic mortgage gets the same rate of protection from those such as non Muslims who may take out a conventional mortgage.
Oh, and us at Wayhome!
We're not a 'bank' but we operate under the Islamic structures of Diminishing Musharaka and Ijarah. We're slightly different to the alternatives in that we buy your home with you and you just rent the part you don't own at a market rate, minus your ownership percentage.
So, if you put in a 5% deposit, we'll pay for the rest.
Then, if that home would typically rent for £1,000 a month, and you owned 5%, you would only pay £950 (95%).
Over time you gradually buy us out until you own the whole thing.
And as you buy more of your home, you rent less of it.
Check out our review from Islamic Finance Guru to see if Wayhome could work for you.
What do you fancy doing next?
Find out what to do if you've recently had a mortgage offer withdrawn
