It is known that conventional banks use interest-based loan contracts as the main instruments to provide finance to their customers. See the fact that interest being prohibited by Islam, contemporary Islamic jurists and financial practitioners have had to adopt and develop a number of financial instruments and products to allow Islamic banks to operate an interest free system.

Islam does not deny that capital deserves to be rewarded, but Islamic teachings present “risk sharing” finance as the most efficient and correct way to provide finance. Therefore, an Islamic financial institution should mainly use profit/loss sharing contracts on both sides of its balance sheet.

On the liabilities side, it invests depositors funds in various types of businesses. A portion of the earned profit is paid to depositors in a predetermined profit sharing ratio. The depositors profit is not and should not be determined in advance. On the assets side, the Islamic financial institution uses various kinds of non-interest based contracts as finance instruments like :

• profit/loss sharing contract (musharaka)
• investment partnership (mudaraba)
• leasing contract (ijara)
• cost-plus financing contract (murabaha)
•  manufacturing or construction finance (istisna).

Almost all of these types of contracts have been or can be used to provide home finance e.i Islamic Mortgage. But The most significant Islamic home finance instruments used are:

1. Diminishing Musharaka (Musharakah Mutanaqisa)
2. Mark-up sale (Murabaha)
3. Islamic Lease (Ijarah or Ijarah Muntahiya Bittamleek)
4. Manufacturing Finance (Istisna or Parallel Istisna)

1. Murabaha-based home finance

1.1 – Definition Of Murabaha :

The term murabaha refers to a special type of sale where the seller has to disclose the costs plus the profit made from the transaction. In order to use the murabaha contract as a financing technique, the Islamic financier incorporates the feature of credit sale (or deferred payment) in the murabaha
contract.

This transaction may be concluded without a prior promise to buy, in which case it is called an ordinary murabaha, or with a prior promise to buy submitted by the customer interested in acquiring goods through the Islamic bank, in which case it is called murabaha to purchase orderer or banking Murabaha. This transaction is one of the trust based contracts because the seller explicitly discloses the purchasing price and profit margin to the buyer.

1.2 – Murabaha Important Principles :

It must be noted that the islamic bank assumes the responsibility of the owner and accordingly bears the ownership risk once it purchases the house form the property owner. It doesn’t merely play a role of a financier. If the property is destroyed or damaged in between the bank’s purchase and its sale to the customer the Bank has bear the loss.

Under Murabaha based islamic mortgage financing structure, it is essential for the islamic bank to buy the asset on fair market value from the Supplier. Hence, it is not permissible for an Islamic Bank to finance the Customer more than the value of the asset.

As oppose to the conventional financing, in Murabaha-based  islamic mortgage, the agreed upon Murabaha sale price cannot be changed even if any deferral in payment is granted to the Customer. It is important to note that if something is sold for a deferred price it becomes a debt over the purchaser which remains unchanged in both the cases of early and late payment. Moreover, after getting into the Murabaha contract, if the islamic bank receives any rebate or discount over the purchased property from the property seller, this amount is either given to the Customer or adjusted in the Murabaha Sale Price.

The whole of the murabaha-based islamic mortgage transaction is to be completed in two different sale contracts: one through which the bank acquires the house, and the other through which the bank will sell the house to the customer The murabaha principle creates a fixed, predetermined indebtedness.
This has made the murabaha principle attractive for Islamic banks as an alternative to interest rate based transactions. However, this mode of finance receives some criticism as it incurs high transaction costs and is inflexible compared to interest based transactions.

Murabaha is a sale contract, this means that the sale price will not change for the duration of the contract. Therefore, the murabaha-based instrument used in islamic mortgage provides a fixed rate of return on home finance.

1.3 – Murabaha-based Islamic Mortgage operational procedure :

The modern murabaha contract has become a very popular technique of financing amongst the Islamic banks as it provides similar risks to conventional interest based loan. The murabaha finance instrument operates in the following way:

1. A Customer who is in need to acquire a house approaches the Islamic Bank and applies for finance through Murabaha (Mark-up Sale) transaction.
2. As per Customer’s financing requirement Bank assesses the customer’s creditworthiness and approves the request.
3. The Bank seeks an undertaking from the Customer to buy the house from the Bank once latter purchases the same and takes the possession thereof. Along with other details the Bank’s profit is also stipulated in such undertaking.
4. If the financing is not approved for the 100% value of the property the Bank asks the Customer to pay certain amount as Hamish Jiddiyyah which is turned into Down Payment at the time of signing the Murabaha Sale Contract.
5. The Bank enters into a property purchase agreement with the property owner and buys the house required by the Customer on the fair market value. The Bank pays the purchase price to the property owner as per agreed term.
6. After getting the possession of the purchased house the Bank sells it to the Customer through a Murabaha Sale Contract after adding its profit (mark-up) to the cost.
7. In accordance with the requirement of Murabaha, the Murabaha Sale Contract clearly stipulates the Murabaha Sale Price which consists of the cost of purchase and the Bank’s profit. The payment term of the sale price is also agreed between the Customer and the Bank in this contract.
8. The Bank hand overs the house to the Customer.
9. The customer pays the Murabaha Sale Price to the Bank as per agreed upon terms and conditions.
10. The Customer may settle his finance early by paying the full outstanding. It is, however, allowed under Shariah for Murabaha Seller (Islamic Bank) to forgo any part of the Murabaha Sale Price at the time of early settlement and grant some rebate on its sole discretion.

2. Ijara-based Islamic Mortgage

2.1 – Definition Of Ijara :

The term ijara refers to a leasing contract. Islamic banks have found that leasing is one of the main recognized types of finance throughout the world and it is a lawful transaction according to Shari’a, therefore it makes perfect sense to develop new financial instruments based on ijara, including home finance instruments. The home finance ijara-based instrument are usually called Ijarah Muntahia Bittamleek (Lease to own) , which is in a way similar to financial lease and hire purchase.

2.2 – Ijara Important Principles :

Under this agreement, the Islamic bank purchases the house selected by the customer, and the customer enters into two contracts with the bank − a leasing contract and a promise to sell. The first contract is a leasing contract where the customer agrees to pay periodic rent to the bank during his occupancy of the house until the end of the ijara contract term, and the second contract is a promise to sell , where the bank undertakes to sell the house to the customer, usually for a nominal price at the end of ijara contract.

The rent paid by the customer can be usually reviewed on a quarterly or semi-annual basis allowing the rent rate to be changed based on an agreed benchmark. The customer pays the bank monthly instalments; each instalment is a combination of a variable rent payment under the leasing contract, together with a fixed payment to pay for the house price which usually will be divided over the term of the contract.

The Ijarah Muntahia Bittamleek (Lease to own) method for home finance has decreased in popularity due to the fact that technically, the customer is paying rent, although part of this rent is to cover the purchase of the property; this part of the rent payment does not create any ownership right as the ownership will only be transferred at the end of the contract when the customer will exercise the promise to sell.

It is worth mentioning that the Islamic Bank takes all the due diligence to ensure that the property subject of lease is intended to be utilized only for the Shariah-compliant activities. The Islamic Bank also terminates any on-going tenancy contract on the property before leasing it to its Customer because the same property cannot be leased twice for any single period.

2.3 – Lease to own-based Islamic Mortgage operational procedure :

1. A Customer who is in need to acquire a house approaches the Islamic Bank and applies for finance through Ijarah Muntahia Bittamleek (Lease to own) transaction.
2. The islamic bank approves the request after examining the customer file carefully.
3. The islamic Bank seeks an undertaking from the customer to lease the house from the Bank once latter purchases the same and takes the possession thereof. Along with all the details of the contract.
4. If the financing is not approved for the 100% value of the property the Bank asks the customer to pay certain amount as advance rental which is adjusted under the first rental period’s rental amount when the Ijarah contract is executed. If the lease, however, has not commenced the Islamic Bank returns the advance rental received from the customer.
5. The Islamic Bank purchases the property from its owner, pays the full purchase price, takes the possession thereof and executes the Ijarah Contract with the customer.
6. The Islamic Bank delivers the property in habitable form to the customer with full access to it in order to start the lease.
7. Under a separate agency agreement, the Islamic Bank appoints its customer (Lessee) as its agent to carry out the major maintenance and obtain the property insurance (Islamic Insurance) policy on its behalf. Along with a fixed fee for these services the Islamic Bank being the Muwakkil (Principal) pays all the costs and expenses incurred under this agency agreement to the Customer (Agent).
8. The Islamic Bank may seek a purchase undertaking from the customer (Lessee) to purchase the house during the lease term in case of any default or breach by the Customer to the Ijarah terms and conditions.
9. In turn the Customer may also ask the Bank to give a sale undertaking to sell the leased property to the customer at the end of the Ijarah term or any time during the lease in order to secure his right to settle the finance early.
10. The rental comprises of two main components, the fixed and variable representing the cost of the property and the Bank’s profit.

3. Diminishing musharaka -based Islamic Mortgage

3.1 – Definition Of Musharakah :

Home financing based on diminishing musharaka and ijara is unique to Islamic finance. It is based on the idea of shared equity rental. Under this housing finance instrument, the customer and the bank jointly acquire and own the house. The bank then leases its share of the house to the customer
on the basis of ijara. The bank will allow the customer to gradually purchase the bank’s share so that the share of the bank reduces and the customer share increases gradually over time, until the end of the contract term, where the customer will become the sole owner of the house.

3.2 – Musharakah Important Principles :

This transaction starts with the formation of the partnership, after which the buying and selling of the equity take place between the two partners. It is therefore necessary that this buying and selling should not be stipulated in the partnership contract. In other words, the buying partner is allowed to give only a promise to buy. This buying and selling agreement must be independent of the partnership contract. It is not permitted that one contract be entered into as a condition for concluding the other. Both the parties, in this case, assume to have the ownership risk in the property in proportion to their capital contribution.

3.3 – Musharakah- based Islamic Mortgage Operational Procedure :

1. The customer approaches the Islamic Bank and applies for home finance through Musharaka Mutanaqisa (Dimnishing Partnership).
2. As per Customer’s financing requirement Bank assesses the customer’s creditworthiness and approves the request.
3. In line with the approved FTV (Finance to Value) both the Bank and the Customer purchase the property in the relevant proportion and pay the purchase price accordingly. In the common banking practice, the Customer’s share is known as Down Payment.
4. The Bank seeks an undertaking from the customer to purchase gradually the entire Bank’s share in the property during the finance period. The Islamic bank may exercise such undertaking to oblige the customer to purchase immediately the Bank’s then share in the property in case of any default or a breach by the Customer.
5. The Customer as per given promise keeps on purchasing the Bank’s share on regular intervals throughout the finance period.
6. Each time when the customer purchases the Bank’s share, a separate sale and purchase agreement is signed by and between the parties.
7. The customer leases the Bank’s portion in the property against the payment of specified rent for a specified period and enters into a lease contract with the Bank.
8. As per the terms of the lease agreement the Customer pays the rental amount to the bank on the due dates which coincide with the date of Bank’s regular sale of its specific portion to the Customer. The rental amount for each rental period is adjusted due to a decrease in the Bank’s share in the leased property.
9. Through a separate agency agreement the Customer is appointed as Bank’s agent to carry out the major maintenance and obtain the Islamic property insurance for the portion of bank’s share in the property.
10. The bank pays all the costs and expenses incurred to the customer under the above said agency agreement. Bank also pays a fixed (generally a very nominal amount) agency fee to the
    customer for his services.
11. To secure its finance, the Bank may place a mortgage over the entire property or seek some other collateral.
12. To secure his right to settle the finance early, Customer may seek an undertaking from the Bank to sell its entire portion to the Customer at any point in time during the finance period.

4. MANUFACTURING FINANCE (ISTISNA AND PARALLEL ISTISNA):

4.1 – Definition Of Istisna’a

The word Istisna’ais a derivative from the root word ‘Sana’a which means to manufacture or to construct or to build something. Istisna’a is a contract of sale of specified items to be manufactured or constructed with an obligation on the part of seller (San’e) to deliver them to the buyer (Mustasne) upon completion.

Another way in which an Istisna is conducted is known in modern custom as Parallel Istisna “al-Istisna al-Muwazi”. It takes effect through two separate contracts. In the first contract, the Islamic Bank acts in the capacity of Seller (San’e) and concludes the contract with the customer who is the buyer (Mustasne). In the second contract, the islamic bank acts in the capacity of a buyer (Mustasne)and concludes the contract with a seller (San’e) in order to fulfill its contractual obligations towards the customer in the first contract. By this process, a profit is realised through the difference in price between the two contracts.

4.2 – Istisna’a Important Principles :

As most of the Islamic Banks are not involved directly in contracting business they adopt the structure of “Parallel Istisna” to satisfy their customers’ need who seek the home finance through Istisna contract. It is a duty of the Islamic bank to ensure that the purpose of Istisna is not repugnant to Shariah priciples.

Since the Istisna is a kind of Sale contract, no penalty or extra amount over the Istisna purchase price shall be charged to the customer (purchaser / mustasne) in case of any delay in the payment or for any deferral in the payment granted by the Bank (seller / San’e) to the Customer. Contrary to this the Customer (mustasne), however, may impose specific penalty against the Bank (San’e) for any delay in the delivery of the property.

4.3 – Itisna-based Islamic Mortgage Operational Procedure :

1. A Customer who is in need to build a house approaches the Islamic Bank and applies for finance through Itisna based finance contract.
2. As per Customer’s financing requirement, the islamic bank assesses the customer’s credit worthiness, analyses the real estate market condition, evaluates the price of the materials of subject property and approves the request.
3. The islamic bank as a seller ( San’e صانع) and the Customer as purchaser (Mustasne مستصنع) execute the Istisna contract whereby the specification of the subject of Istisna, Istisna price, the mode of payment and the delivery of the property are stipulated in a very clear form.
4. If the financing is not approved for the 100% value of the Istisna cost, the islamic bank asks the Customer to pay certain amount as advance payment which is adjusted in the Istisna purchase price.
5. The islamic bank, in turn, executes another Istisna contract (parallel Istisna الاستصناع الموازي) being purchaser (Mustasne) with any contractor (San’e) on the same terms and conditions of the Istisna agreement signed with the customer except the Istisna price. In the parallel Istisna contract, the Bank may ask the contractor to provide with a performance guarantee and in case of any advance payment, the advance payment Guarantee.
6. Under the Parallel Istisna contract, the islamic bank as Mustasne pays the Istisna price to the contractor i.e. San’e, as per agreed upon terms in the agreement. The payment is generally linked to the progress of construction.
7. A consultant is appointed either on the cost of the contractor or the customer to supervise the construction works.
8. The Contractor as a San’e delivers the property on the delivery date to the islamic bank (mustasne) under the parallel Istisna contract.
9. The Bank being (San’e) delivers the property under the first Istisna contact to the Customer (mustasne) on the relevant delivery date.
10. The Customer pays the Istisna purchase price to the islamic bank as per agreed upon terms in the contract which generally starts after the delivery of the property to the Customer in the form of Equated Monthly Installment (EMI).