Under the Islamic mortgage system, the Islamic bank charges the customer a monthly rent based on the bank share in the house, in addition to the monthly instalment of the principal amount (loan/equity). In simple words, the bank charges the house rent rather than service charges (interest) on loans.

A sharia-compliant mortgage is offered mainly in four forms.

Diminishing Musharakah and ijarah 

Musharakah means partnership and ijarah means “to give something on rent”. Both are Islamic financing terminologies. So, under this option, the bank and the customer make a partnership to buy a house, and the customer then takes the house on rent. Let’s look into this in further details.

A home buyer and a bank buy the property together (in joint ownership of the property). It is a type of co-ownership, and the transaction is not based on lending or borrowing of money but joint ownership of a house.

Thus the bank and the customer share the cost of the house being purchased. Bank will provide a certain amount of financing. Gradually transferring ownership to the customer, in return of monthly instalments to the bank composed of rent and part of equity share (principal amount). The monthly payment is reduced regularly as the share of a customer grows in the property. That is why it is called diminishing Musharakah (as a partnership shrinks with each payment). After the full investment, on agreed terms, the customer becomes the sole owner of the property.

Murabaha

The bank buys property for the client and immediately sells to the client for a profit. The customer pays fixed monthly repayments without paying interest to the bank. It is also referred to as cost-plus profit financing in which the bank establishes a contract setting the cost and profit for the property and client repay it through fixed instalments. This option is less popular as customer needs to pay a very large initial amount of capital while the lending term is typically no more than 15 years, particularly in the UK.

Parallel Istisna

Istisna is a contract whereby a manufacturer/developer undertakes to manufacture, build or construct an asset and deliver it to the customer upon completion according to the specification. Payments can be made in instalments according to project completion, at delivery or after project completion. In simple/classical Istisna contract involves two parties which are the customer and the manufacturer. The bank pays as agreed during development and developers delivers specified goods later.

Parallel Istisna consists of two series of separate contracts, in which the first contract is between the bank and the property developer. The second contract is between the customer and the bank.

Commodity Murabaha (Tawarruq)

It is based on the shariah principle of Murabaha (cost-plus financing), where the bank provides financing to the customer by the trade of identified shariah-compliant commodities such as crude oil, RBD palm oil and non-precious metals.
The bank acts as Wakalah (both purchasing and selling agent of commodities on customer behalf). The customer asks the bank for cash financing (home financing), where the bank purchases an asset or commodity from a broker for entering into commodity Murabaha transaction. The customer buys an asset from the bank for a deferred payment (either periodic instalment or lump sum settlement). The customer subsequently sells the asset (via agent-Bank) to the third party for cash at a price less than deferred price, with obtaining cash.

Both parties agreed to the transaction terms, which include details about price, time and type of commodities.