Are Islamic finance products actually interest-free?

Islamic finance is often misunderstood. Here’s a look at the facts behind these faith-based loan products.

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Islamic or Sharia-compliant home loans don't charge interest in the same way traditional mortgages do. But this doesn't make them cheaper for the borrower. The existence of Islamic finance comes down to Islam’s belief that usury - or charging interest - is unacceptable.

As such, Muslims looking to borrow to buy a home while still remaining true to the tenets of their faith must look for other options. Islamic finance overcomes the hurdle of charging interest by instead purchasing a home in partnership and selling it back to the buyer over a pre-determined period of time.

Compare traditional mortgages here

This set-up isn’t charity, nor does it deliver borrowers an edge on traditional home loans. The way many Islamic finance products are structured, the lender will co-purchase the property with the borrower. The borrower will then make weekly rental payments that are calculated as a percentage of the original purchase price of the house. In so doing, they purchase the lender’s share of the property with a lease-to-own agreement.

Rent for the property is calculated as a percentage of the original purchase price, and this percentage is determined based upon the lender’s cost of funds, fair market rents and operating and management costs. Because the lender is assuming some of the risk by legally owning a large portion of the property, this percentage can often be higher than current traditional home loan interest rates.

If we assume a rent that is 4.99% of the original purchase price (the current scenario presented on the website of MCCA Islamic Finance & Investments, one of Australia’s main Islamic finance specialists), a $350,000 lease-to-own agreement would see the borrower pay a total of $675,625.40 over a period of 30 years.

Now let’s compare this to a typical home loan wherein the borrower is charged interest. A look at the home loan calculator below shows that the total cost of finance for a 30 year home loan at a 4.99% interest rate is $675,625.40, the same amount a borrower would pay for a Sharia-compliant home loan.

Islamic finance 4

This would seem to undercut the argument that Islamic finance provides Muslim borrowers with a leg up on the competition from the price perspective. But Islamic finance products are unique when it comes to risk sharing.

Because the borrower is buying equity in the home over time rather than assuming debt, they are more protected than in a traditional home loan. Citigroup chief economist Willem Buiter recently told the Australian Financial Review the products offered greater protection to borrowers than traditional home loans.

“If you have disruption in your employment you can stop buying equity in the house or even sell back what you have already bought – the chances of eviction and dispossession are much lower,” he said.

This would seem to offer an advantage to borrowers in Islamic finance arrangements. However, the products are not exclusive to Muslim borrowers. Any borrower, Muslim or non-Muslim, can access Islamic finance products. But because the products are often more expensive than traditional home loans, there is no real financial advantage. The primary selling point of Islamic home loans is an ethical one, not a financial one.

Compare a wider range of home loans from non-Islamic lenders

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years
Name Product Interest Rate (p.a.) Comp. Rate^ Application Fee Ongoing Fees Max LVR Monthly Payment
Westpac Flexi First Option Home Loan
2.29%
2.72%
$0
$8 monthly ($96 p.a.)
95%
$577.55
Up to $3,000 refinance cashback.
A flexible and competitive variable rate loan. Eligible borrowers refinancing $250,000 or more can get $2,000 cashback per property plus a bonus $1,000 for their first application. Other conditions apply.
St.George Basic Home Loan
2.54%
2.56%
$0
$0 p.a.
80%
$596.91
Up to $4,000 refinance cashback. With this competitive variable rate loan from St.George, refinancers borrowing $250,000+ can get up $4,000 cashback and borrow up to 80% of the property's value. (Terms, conditions & exclusions apply).
HSBC Fixed Rate Home Loan
1.88%
2.98%
$0
$0 p.a.
80%
$546.6
Lock in a competitive fixed rate for 2 years and buy your home with a 20% deposit.
Macquarie Bank Basic Home Loan
2.49%
2.49%
$0
$0 p.a.
60%
$593.01
A competitive variable rate home loan for owner-occupiers. Requires a 40% deposit.
UBank UHomeLoan Variable Rate
2.34%
2.34%
$0
$0 p.a.
80%
$581.39
Enjoy flexible repayments, a redraw facility and the ability to split your loan. Plus, pay no application or ongoing fees.
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Westpac Flexi First Option Home Loan - Basic Variable Rate (Owner Occupier, P&I)

Up to $3,000 refinance cashback. A flexible and competitive variable rate loan. Eligible borrowers refinancing $250,000 or more can get $2,000 cashback per property plus a bonus $1,000 for their first application. Other conditions apply.

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St.George Basic Home Loan - LVR 60% to 80% (Owner Occupier, P&I)

Up to $4,000 refinance cashback. With this competitive variable rate loan from St.George, refinancers borrowing $250,000+ can get up $4,000 cashback and borrow up to 90% of the property's value. (Terms, conditions & exclusions apply).

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Athena Liberate Home Loan - 70% to 80% LVR Owner Occupier, P&I

A competitive variable rate mortgage for owner occupiers $0 application and $0 ongoing fees. This interest rate falls over time as you pay off the loan.

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4 Responses

    Default Gravatar
    MohdJanuary 15, 2018

    Sir mujhe home loan ki jarurat he sir
    Pliss Sir

      Default Gravatar
      ArnoldJanuary 16, 2018

      Hi Mohd,

      Thanks for your inquiry

      You can compare you options for a home loan by clicking on this link. Please note that eligibility requirements may vary among lenders. Be sure to check them before applying to avoid being declined.

      Hope this information helps

      Cheers,
      Arnold

    Default Gravatar
    TanvirJuly 12, 2017

    What is the percentage of deposit?

      Default Gravatar
      JonathanJuly 19, 2017

      Hello Tanvir,

      Thank you for sending your question. :)

      Most Islamic home loans still require 20% deposit. Please take note that this may vary per lender and would also be dependent on your credit status.

      Hope this helps.

      Cheers,
      Jonathan

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