What is Shariah Finance?

Under Shariah Islamic Law, making 'money from money' such as charging interest is considered usury and therefore strictly forbiddon. Wealth can only be generated through legitimate trade and investment in assets. Since the princple means of Shariah Finance is based on trade, transactions should involve shared
risk. Any gains relating to the trading are shared between the person providing the capital and the person providing the expertise. Likewise, any risks are also shared on agreed terms.

The two most widely usd catergories in Shariah finance are Murabaha and Ijara.

Murabaha

Murabaha is a popular form of islamic finance where the customer can take credit without having to take out an interest bearing loan. Usually, the bank will buy the property and resell it to the customer at a higher mark up. Most banks require a downpayment of around 10%. The remaining 90% share is owned by the bank.

Over a period of up to 25 years, you will make monthly purchase instalments through which the Bank will sell its share (90%) of the home to you. With each instalment paid, the Bank’s share in the property diminishes while your share correspondingly increases.

Ijara

Using the Ijara principle, the bank purchases the property and then leases it to the customer. For example, a bank may contribute 90% of the purchase price and require the customer to pay the remaining 10%. This now gives the customer a 10% share in the property. Over a period of 25 years (may vary depending on bank), the customer makes monthly payments in which the bank gradually sells its 90% share to the customer. With each instalment paid, the bank's share diminishes while your share correspondingly increases.

While the purchase instalments are being made, the bank will charge you rent for use of its share of the property, the rent being calculated according to the respective shares being owned.

Many may argue that this is litttle different to a conventional mortgage. This is because in both methods, the amount paid in montly instalments may be similar. However, unlike a conventional a conventional mortgage where money is made purely through interest on the amount borrowed, the bank makes its profit through the property's physical use via your occupation as a tenant.

This is one of the fundemental differences of Islamic finance, where you can charge for the use of something physical, like a property, but you cannot charge for the use of money because this is considered interest.

Isn't all this just the same as a conventional interest based mortgage?

Murabaha and Ijara differ from a conventional interest based mortgage because firstly, NO INTEREST is involved. Secondly, the bank owns the property therefore sharing the risks associated with property ownership. This is very different from conventional mortgages where the bank never actually owns the property.

Furthermore, in a conventional mortgage the customer is the borrower. However in a Ijara/Murahaba structure, the customer is essentially a partner in the property. This unique relationship between the bank and its customer presents both parties with shared risk, a concept that is very rare in an interest based mortgage.