How Islamic Home Finance Works

http://www.ethicainstitute.com In 2009 Nick lost his job, his house, and all the money he had spent paying off his mortgage.

The property bubble that triggered the global financial meltdown could not have happened if the properties had been financed Islamically. Why? Because a conventional bank merely lends out cash. Legally, it can keep lending this cash over and over. Well above its actual cash reserves.

An Islamic bank, on the other hand, has to take direct ownership of an actual asset. Whether for a longer period in a lease or partnership, or a shorter period in a sale or trade, Islamic finance always limits the institution to an actual asset.

The next time anyone wonders whether Islamic banking is just dressed up conventional banking, ask them to show you a single major consumer bank that co-owns actual properties with their customers.

Of course, there's no excuse for Islamic banks that are Islamic in name only. But if the transaction complies with internationally recognized standards like AAOIFI, for instance, then there's no reason for it to have the many side effects associated with interest-based banking.

To provide just one example of how Islamic banks get directly involved in asset purchases, let's look at how a Diminishing Musharakah works. The word Musharakah refers to a partnership in Islamic finance.

And it's called a Diminishing Musharakah because the banks equity keeps decreasing throughout the tenure of the financing, while the client's ownership keeps increasing through a series of equity purchases. Eventually, the client becomes the sole owner.

If Nick had lost his job, with a Diminishing Musharakah, at the very least, he would still have an equity stake in an actual property that he could monetize.

Pay close attention to this example because this is something you may want to suggest to your own local bank. There's no reason why they can't do it.

We've kept all the numbers and calculations very simple and straightforward for illustration purposes.

At no time does the homebuyer pay any interest. And, certainly, at no time does any payment compound. The homebuyer just pays for two things: the house, in small payments, little by little. And the rent, for the portion of the house he doesn't yet own.

This simple structure is something that just about any conventional bank can offer today. It takes a leap of faith for banks accustomed to all-cash interest-based lending to suddenly become direct stakeholders in property. But as the growth of Islamic banking shows, these concerns are misplaced. Call it Islamic finance, ethical finance, or conventional finance, when a bank takes real ownership of an asset, economies don't fall apart like a house of cards.

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