SHARIA-COMPLIANT MORTGAGES

Some ATG members have been approached to insuresharia-compliant mortgages in recent years.Shariais the Islamic legal code, and it contains certain prohibitions that affect financial transactions. This article explains theshariaprohibitions and how lenders have reacted, providing alternative financing products to Muslims.

Sharia prohibits the use ofribain any transaction.ribaliterally means "excess" or "increase" in Arabic. The term refers to unearned compensation, often in the form of money earned without effort or without typical market risk. Scholars often defineribaas usury. There are two forms ofriba. A rental rate attached to the borrowing of money - or interest - is one form ofriba, known asriba an-nasia. When a borrower must return more than the sum that the lender provided, the borrower and lender are engaging inriba. The other form ofriba,riba al-fadl, refers to the borrowing of goods, and occurs when the borrower provides goods of superior quality in return for goods of inferior quality. The use of either form ofribais condemned in Islamic law.

Many of the transactions in the world market today require—are not possible without—financing that involves interest. This is true when building a skyscraper or buying a home. As a result, many Muslims are very careful about how and where they spend their money, many choosing not to buy a home because they fear the only way they can afford to buy rather than rent is withriba.

As a result, lenders have sought to find alternative methods of financing as a means for Muslims to make relatively large purchases without fear ofriba. Banks are able to provide interest-free loans to Muslims because while Islam clearly forbidsriba, Islamic law allows Muslims to make money from a transaction. For example, whileshariawould prohibit a lender from lending a borrower $100 to buy a widget and then requiring the customer to pay back $120,shariawould allow a lender to buy a widget at $100 and sell it to the borrower for $120 when the borrower has saved up enough money to buy the widget.

Permitted Financing Arrangements

Islamic banks have developed three forms of financing that they purport meetshariarequirements:Murahaba,Musharaka, andIjara.

Under theMurahabamodel, the customer identifies a property to buy and negotiates a price with the seller. The financier then buys the property, taking title to the purchased property. The financier may create a special purpose LLC for the purchase. (Janice E. Carpi,Insuring Title under Islamic Restricted Financing, Real Property Probate and Trust Law Section's 15th Annual Real Property and Estate Planning Symposium, May 12-14, 2004;http://www.abanet.org/rppt/meetings_cle/spring2004/rp/Titleinsurance/carpi.pdf). Next, the financier charges the customer the price the financier paid for the property plus a profit that the customer pays the financier over an agreed upon length of time. Title to the property may transfer to the customer either at the time the customer begins payments or when payment is complete.Id.

Under theIjaramodel, the financier purchases the property on behalf of the customer. Then the financier charges the customer rent for an agreed upon period of time during which the customer occupies the property. At the end of the time period, the customer has the option of buying the property for the amount of the original acquisition. (Janice E. Carpi,Insuring Title under Islamic Restricted Financing, Real Property Probate and Trust Law Section's 15th Annual Real Property and Estate Planning Symposium, May 12-14, 2004;http://www.abanet.org/rppt/meetings_cle/spring2004/rp/Titleinsurance/carpi.pdf).

Under theMusharakamodel, the financier and the customer enter into a partnership agreement to purchase the property. The customer pays some of the purchase price, and the financier pays the remainder of the price. The customer and the financier share the profits of the property according to an agreed upon ratio. Both parties share the losses, profits, and maintenance responsibilities.Id.

ATG has insured a few mortgages that use theMusharakamodel because this model's purpose is to produce a mortgage that can be sold on the secondary mortgage market, and therefore these mortgages require title insurance. Guidance Financial Group makes many, if not all of these mortgage loans. In these transactions, Guidance Financial Group creates a limited liability company (LLC) to enter into the partnership agreement and take title to the property. The LLC has a numeric identifier. Together, the LLC and the borrower buy property, each contributing money to the purchase and both named as grantees on the deed from the seller. The borrower and LLC sign a co-ownership agreement, which dictates the terms of their relationship, and explains that the borrower will buy out the LLC's interest in the land. The co-ownership agreement includes a detailed amortization schedule that indicates the relative percentages of ownership between the borrower and LLC after each payment and identifies how much of the payment represents acquisition costs and how much represents profit for the LLC. The borrower also signs a promise to repay the loan and a mortgage, mortgaging his or her interest in the land to the LLC. The LLC assigns its mortgage to the lender, and, in the same document, the LLC mortgages its interest in the property to the lender. Thus, the lender acquires a mortgage on the complete title to the land. The deed, mortgage, and assignment are signed at once at the closing and recorded in order.

Sharia-Complaint Mortgages and the National Economy

These new forms of financing have provided a product that is in great demand. It is estimated that approximately one third of the 7.5 million Muslims in the United States refuse conventional mortgages due to their violation ofsharialaw. (Carrie Tait, "Faith-Based Mortgages Court Muslims,"Financial Post, Canada;http://www.canada.com/nationalpost/financialpost/story.html?id=01ff2407-f4fe-4c16-80ad-1172d0d25763&k=5052). Additionally, about 40% of Muslims in the United States do not own a home.Id.If financial institutions could convince only 1.25% of these potential home owners to execute a mortgage, the market would instantly be worth about $1.75 billion.Id.Therefore, a higher prevalence of Islamic financing would help the economy, in addition to providing home ownership for those people who would otherwise not have that option.

However, harmony between religion and financing comes at a cost. In the United States,sharia-compliant mortgages come at a cost of between 40 and 100 basis points more than conventional mortgages.Id.Additionally, processing fees for the additional time and paperwork that go intosharia-compliant mortgages are higher than those for conventional mortgages. However, these fees are typically minimal in relation to the cost of buying a home and will not likely deter many from entering into these transactions. (Dennis Radkin, "Faith, Finance,"Chicago Tribune, February 6, 2005).

Unresolved Issues

There are two more problems with these types of financing that are currently unresolved. First, few people buy a house with a 15- or 30-year mortgage and remain in that house for the whole term. With an interest-bearing loan, that is not a problem because it is fairly simple to compute the amount still owed to the bank to generate a payoff letter.Id.However, under Islamic financing, the bank and the owner must share any increase in home value, which is directly adverse to typical home financing in the United States.

The other problem involves the tax break Americans receive, due to the deduction of mortgage interest they have paid each year.Id.To comply with federal mortgage regulations, banks must report the amount borrowers paid that would have been interest in a standard loan. However, borrowers may feel that this conflicts withsharialaw because it is premised on the paying of interest. The IRS has not yet determined what it will require under these circumstances.

Ultimately, the current problems associated withsharia-compliant mortgages boil down to extra costs to the borrowers. Until these mortgages become more prevalent, with clearer guidelines and end results, it is simply up to the buyers to determine whether home ownership, in accordance with their religious beliefs, is worth the extra costs and potential uncertainty.