One of the first questions you’ll be asked when you enquire about home financing at a bank is: “Do you prefer Islamic home financing or conventional financing?”
This doesn’t have to be a difficult choice! Read on to understand what Shariah compliant Islamic finance in Malaysia is all about, so that you can make the best decision for your home loan.
What is Islamic home financing?
This is essentially a home loan that is Shariah compliant. What this means is that the income derived from the transaction should not be unlawful or haram, according to Islamic law (also known as Shariah) and Islamic economic principles.
There are two key elements of Islamic finance in Malaysia:
- It does not contain any element of money-lending or interest (riba).
- It prohibits the property to be used for purposes that are illegal, immoral, or not Shariah compliant.
There is, however, NO religious requirement; both Muslims and non-Muslims are welcome to choose the Islamic finance option for their home loan.
How does Islamic financing work?
Any Islamic finance product that’s Shariah compliant aims to make a profit through the sale of the asset involved.
Simply put, it means the bank will buy the item at the offered price, and sell it back to the buyer at a marked-up price.
The difference between the initial sale price and the mark-up is the bank’s pre-determined ‘profit’. This is known as the principle of Murabahah and removes the element of riba from the transaction.
How does an Islamic loan differ from conventional home loans?
Most banks will tell you that there’s really not much of a difference between Islamic banking and conventional banking. To a certain extent, this is true – they’re not just trying to get your money!
Even though there’s no interest rate in Islamic home financing, the instalment that you pay after the mark-up will be almost the same as the instalment of a conventional loan which includes an interest rate.
This is done to maintain the competitiveness of Islamic banking in Malaysia. In fact, Bank Negara Malaysia (BNM) aspires to grow this particular industry to 40% of Malaysia’s financial sector by the end of 2020.
How does that apply to property financing?
Similar to conventional home loans, you will still need to prepare a 10% down payment for the property, while the remaining 90% will be financed by your Islamic finance institution.
At this point, you will enter into one of the following types of contracts with your bank:
- Bai Bithamin Ajil (BBA), which is a sale contract, where the bank sells the asset to you with payment on instalment terms.
- Musyarakah, which is a partnership contract, where you and the bank jointly own the property. Once you finish your repayments, you acquire full ownership.
- Ijarah, which is a leasing contract, a type of ‘rent-to-own’ scheme. You will have the option to buy off the property at the end of the contract.
This differs from the conventional lending contract, where the bank profits from charging compounding interest on the money that is being lent to you.
What are the advantages of Islamic home financing?
The difference between Islamic banking and conventional banking is not major, but it can actually work out more in favour of Islamic finance in Malaysia:
Base Rate
The bank’s ceiling profit rate is based on the Islamic Base Financing Rate. While this can be adjusted based on market conditions, it cannot exceed the pre-determined ceiling rate.
The interest rate is based on a conventional Base Rate (BR). This can be adjusted based on market conditions without any ceiling. So if there is a major interest rate hike, you may end up paying a much higher instalment amount.
Late Repayments
As profit is calculated based on the outstanding principal only, late repayments should incur lower penalties.
As interest is calculated on a compounding scale, late repayments can incur comparatively higher penalties.
Early Settlement
You can exit the contract at any time without penalty, as long as you fairly settle your outstanding obligations.
Due to a lock-in period, you could incur a hefty exit penalty if you opt for an early settlement.
What are the drawbacks?
Of course, no financing product is entirely without drawbacks. These are the limitations of Islamic banking in Malaysia:
- There are more legal documents involved for Islamic banking in Malaysia, so your legal fees may be significantly higher.
- Any Islamic finance loan restructuring requires a whole new contract agreement to be created and signed. This is more expensive than conventional loans, which only requires the amendment to be stamped.
What are some of the things I should consider before taking up an Islamic home loan?
Islamic finance products and Islamic banking in Malaysia are comparatively new, making their debut only in 1983.
Due to this, some of the contractual terms may not be as transparent as conventional home loan contracts.
Hence, it’s better to look for a lawyer that is well-experienced in handling Islamic finance contracts so that they can help ensure you are better informed as well.
Also, do take note of the the Shariah requirement that no haram activities can be carried out within the property, especially if the property is a commercial one.
What are the requirements and application process like for Islamic home loans?
The application process for Islamic home financing is the same as a conventional one. Normally, the documents required are:
- NRIC
- Copy of Sale and Purchase Agreement (SPA) or Booking Receipt or Letter of Offer from Developer
- Copy of Individual Title Deed
- Property Valuation Report (for completed properties)
- Latest 3 months salary slip or latest 6 months commission statement
- Latest 3 months Employees Provident Fund (EPF) statements
- Latest EA form
- Latest 6 months Bank Statement
- Letter of Confirmation of Employment and Remuneration
So there you have it! There’s not much difference between Islamic banking and conventional banking, but there are minor variances that are worth taking into consideration.
Either way, don’t be shy to ask your bank questions about their Islamic finance and Shariah compliant products, and most importantly, do a thorough research before you sign the dotted line!