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What Is an Islamic Mortgage? How Interest Is Avoided

Islamic mortgage

Mortgage Q&A: “What is an Islamic mortgage?”

There are a variety of different types of home loans out there, some pretty conventional and some a little less so.

One you may have heard about, but might not be clear on is an “Islamic mortgage,” which as the name implies, is intended for someone of the Muslim faith.

The Problem Mortgage Lenders Face

  • Most home buyers need a mortgage to purchase a property
  • Since home prices are so expensive and very few people have ample cash on hand
  • But the payment or receipt of interest is prohibited according to certain religious beliefs
  • Which requires different alternatives to finance the property

If you’re wondering why a mortgage would need to be crafted based on someone’s religion, take note of the following.

Under the Sharia law of Islam, the payment or receipt of riba (also known as interest) is prohibited, and thus a conventional mortgage that charges interest each month cannot be utilized by a practicing Muslim.

Obviously, this poses a potential problem, as home prices are typically far too expensive to allow a prospective home buyer to purchase outright with cash.

The Solution(s)

  • There are three ways this issue can be resolved
  • One being to sell the property at a higher price under an installment plan
  • Another being a “lease to purchase” contract
  • Or to create an LLC and own shares in the property

However, this can be solved by having the bank purchase the property and sell it back to the mortgagor (borrower) in one of three ways.

The bank will either sell the property at a higher price to the borrower under an installment plan, or rent it to the tenant/homeowner, and have them pay a contribution toward the principal balance of the home each month until it is paid off in full.

The rent price is typically established by looking at comparable homes in the area where the subject property is located.

The second method is also known as “lease to purchase” because the homeowner “rents” the property while paying down principal and gaining home equity. Once a significant chunk has been paid down, they might be able to buy the property outright with cash.

A final option is to create an LLC whereby the finance company and the home buyer own shares in the property.

With regard to the western world, Islamic Mortgages are probably most common in the United Kingdom, although they seem to be gaining steam in the United States as well.

Fannie and Freddie Are Investors in Islamic Mortgages

  • Fannie Mae and Freddie Mac invest in these types of loans
  • This allows smaller banks and lenders to offer them to customers
  • Default rates are probably a lot lower than other mortgages
  • Due to the straightforward terms and absence of high-risk features

In the early 2000s, mortgage financier Freddie Mac agreed to buy these types of “mortgages,” and at this point, others probably wish they had too.

Because Islamic mortgages tend to be more straightforward than some of the exotic offerings seen in traditional Alt-A and subprime lending, the homeowner default rate is probably a lot lower.

Fannie Mae is also an investor in these types of loans, which they refer to as “no-interest financing,” and in lieu of a mortgage, they become an investor in the property itself.

This allows smaller banks and mortgage lenders to offer the option and then sell it to Fannie or Freddie so they have funds to make new loans to future customers.

The lack of trickery and bait-and-switch has encouraged more Muslims to consider an Islamic mortgage, as it further justifies the choice.

Similar Rules Apply to Those of Jewish Faith

There is a similar Jewish law that prohibits Jewish individuals from charging interest to other Jews.

Recently, Quicken Loans had to make a change because the company is reportedly majority-owned by Jews.

Instead of considering the home loans the company makes as interest, they will now be known as a “co-investment” between the homeowner and the lender.

This was a pretty big deal (and important fix) considering Quicken Loans and its Rocket Mortgage are now the top mortgage lender in the United States.

9 thoughts on “What Is an Islamic Mortgage? How Interest Is Avoided”

  1. I own property in Los Angeles I was looking to refinance the Islamic way. Could you please provide details how could this be done.

  2. Hi Syed,

    Probably best to seek out a lender (or mortgage broker) that specializes in Islamic mortgages in the LA area to help you navigate the process and answer any specific questions.

  3. I am pleased and relieved to see these type of loans on the open market in the U.S. However, I am not clear on how these loans make money or profit for the lenders. Also, I am currently obtaining my Real Estate license in the state of California. How do I locate businesses that handle these type of loans to do business with.

  4. Judith,

    The solutions section of the post details how they can make money, one being selling the property above market price. As to who offers such financing, I don’t know of individual lenders offhand. They may vary by state or region.

  5. Guidance Residential is one of the largest Islamic mortgage providers in the US. They don’t serve all states though so you would have to check out their website.

  6. How is this interest free? This is another way of making money. Person X wants to sell a property for S1 amount. Person Y is interested and approaches Muslim bank. Bank buys the property at S1 and agrees with Y to give it to him at a higher S2 rate, That means Y ends up paying more than the said price where the difference is sort of an interest defined in another way – maybe slightly lesser than normal banks but technically it is an indirect interest.

    In a real sense, NO INTEREST would be when the bank helps the the buyer to pay S1 amount in installment – ONLY then it would be true to say that taking interest is prohibited & is not being charged.

  7. Mortgage my property (flat) and took loan from Islamic bank it covers full loan for business. Subsequently my business fall down due to covid. Bank took blank check to cover the loan. I can’t repay loan bank sue against me criminal case, civil case now my question is that if i cover my loan by giving mortgage which cover entire loan how can bank sue against me? How i can get relief in the eye of sharia law Mortgage please let me know the solution.

  8. That’s a good question – I don’t know how payment default is handled under this type of arrangement. Perhaps there is an explanation in the loan documents or paperwork that was originally signed.

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