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

$
years
Name Product Interest Rate (p.a.) Comp. Rate (p.a.) Fees Monthly Payment

UBank UHomeLoan Fixed P&IHome 1Y Fixed≥ 20% Deposit

UBank UHomeLoan Fixed
1.79%
2.32%
  • App: $0
  • Ongoing: $0 p.a.
$540
Fix your mortgage for 1 year with a very competitive rate and no ongoing fees.

loans.com.au Smart Booster Discount Variable Home Loan P&IHome≥ 20% Deposit

loans.com.au Smart Booster Discount Variable Home Loan
1.85%
2.21%
  • App: $0
  • Ongoing: $0 p.a.
$545
Get a low discounted variable rate loan. Requires a 20% deposit. Get your loan processed fast and settle within 30 days.

Athena Variable Home Loan P&IHome≥ 40% Deposit

Athena Variable Home  Loan
1.99%
1.99%
  • App: $0
  • Ongoing: $0 p.a.
$555
Owner occupiers with 40% deposits or equity can get this competitive variable rate loan. No upfront or ongoing fees.

Nano Variable Home Loans P&IHome≥ 25% Deposit Refi Only

Nano Variable Home Loans
1.99%
1.99%
  • App: $0
  • Ongoing: $0 p.a.
$555
Switch to this competitive variable rate with zero fees. Requires a 25% deposit.

HSBC Fixed Rate Home Loan Package P&IHome 2Y Fixed≥ 20% Deposit

HSBC Fixed Rate Home Loan Package
1.88%
2.86%
  • App: $0
  • Ongoing: $390 p.a.
$547
$3,288 refinance cashback offer
Lock in a low fixed rate for 2 years and buy your home with a 20% deposit. Eligible refinancers borrowing $250,000 or more can get a $3,288 cashback. Terms and conditions apply.
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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.

      If you are searching for a home loan in Australia, you may refer to our list of latest home loan offers. On the page, is a comparison table you can use to see which lender suits you.

      You may click the name of the lender or the “More info” link to be redirected to our review page and learn more about the lender’s loan offer, rates, and requirements as well as the pros and cons of using their loan service. When you are ready, you may then click on the “Go to site” button and you will be redirected to the lender’s website where you can proceed with the application or get in touch with their representatives for further inquiries you may have. Alternatively, you can speak to a mortgage broker who can take your personal circumstance into account and offer you a range of borrowing options.

      If you are looking for a home loan in India, I’m afraid we don’t have a dedicated page yet for a list of lenders in your country. You may reach out to your local bank or credit union instead.

      Before applying, please ensure that you meet all the eligibility criteria and read through the details of the needed requirements as well as the relevant Product Disclosure Statements/Terms and Conditions when comparing your options before making a decision on whether it is right for you. You can also contact the provider if you have specific questions.

      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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