Are Islamic finance products actually interest-free?

Rates and Fees verified correct on December 5th, 2016

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

How islamic finance worksIslamic or Sharia-compliant home loans can be a sensitive subject. They’ve lately drawn criticism from newly-elected One Nation senator Pauline Hanson, who claimed in a Facebook post that the products were unfair, and put non-Islamic borrowers at a disadvantage because the products don’t charge interest.

At first glance, an interest-free home loan available to members of a certain faith community would seem unfair. But to get to the truth behind these claims, it’s important to understand how Islamic finance works.

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.

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.

Adam Smith

Adam has more than five years of experience writing about the Australian home loan market.

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