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Islamic banking and financing, particularly Islamic property financing, in Malaysia is considered one of the most renowned and established in the world. Islamic banking which follows Shariah laws has been in operation since the enactment of the Islamic Banking Act in 1983 and the establishment of Bank Islam Malaysia Berhad on the same year.
The new law and the institution of a new bank paved the way for the continuous development of Islamic banking and finance in Malaysia.
How does Islamic property financing work?
In a nutshell, Islamic banking is a system that follows Islamic Laws (Syariah) principles and Islamic-based economics. Islamic principles dictate that money lending (interest-based) as well as investing in businesses that are considered haram (unlawful) are prohibited.
The concept of Islamic finance lies in providing financing to consumers based on pre-determined profits rather than dealing with interest.
To consumers, whether Muslim or otherwise, Islamic Banks have much greater social and moral responsibilities to ensure that their principles of financing are fair to everyone.
Under Islamic property financing, banks are required to buy an asset (i.e. property) from the seller and sell it back to the buyer (you) with profit. The buyer will be allowed to pay for the property in installments.
Technically, it works in similar fashion to a conventional home loan where the customer pays 10% down payment (customer’s equity) and the bank will finance the balance of 90% (bank’s equity).
What are the advantages?
Essentially, Islamic banks follow two types of Islamic banking principles – Bai’ Bithaman Ajil (BBA) and Musharakah Mutanaqisah (MM).
MM is the latest financing concept introduced, and has eliminated, though not entirely, the previous issues associated with BBA. Here we will further explore the advantages and drawbacks will be focused on MM.
Other than providing greater social and moral responsibility and fairness, Islamic property financing offers quite a few advantages, such as:
- Fixed monthly repayment to help customers balance their monthly budget.
- Cost of stamp duty lower by 20%. As set out in Budget 2007, stamp duty for an Islamic property financing is discounted by 20% as compared to a conventional loan. Furthermore, stamp duty is waived for the redeemed amount when refinancing from a conventional loan to an Islamic home finance.
- Penalty fee for property disposal within the lock-in period can be potentially lower than a conventional loan. A conventional loan’s penalty fee for early settlement (prepayment) is a set percentage, whereas the Islamic bank will charge based on the bank’s prevailing cost of funds. However, the fee differs from one Islamic bank to another.
- Unlike conventional loans, which are based on Base Rate, Islamic loans are based on Base Financing Rate (BFR) which the bank can actually adjust based on prevailing market conditions but not more than the ceiling rate, which is the maximum profit an Islamic finance provider will earn.
What are the drawbacks?
There are two sides to every coin, and though the good seems to outweigh the bad, here are some of the main weaknesses of Islamic property financing:
- The floating rate penalty charge may be less desirable during the high interest rate regime.
- Even though the concept is sound, the calculation method adopted by each bank differs significantly. Though the outcome may not be detrimental to the bank or the consumer, due to the restriction in procedure, a degree of uncertainty exists for both the bank and the customer.
- Alteration of terms of financing may be more troublesome. Should a customer choose to alter the terms of financing, a new Sale and Buy-back agreement needs to be created and signed. A conventional loan would only require the amendment to be stamped which incurs less cost.
Boosting take-up of Islamic property financing
The government has been introducing various measures to make Islamic financing more attractive. With the target of boosting Islamic banking assets to 40% of the total by 2020 from 24%, a 20% discount on stamp duty was introduced.
According to CIMB Group Holdings Bhd to The Star, Islamic home loans in Malaysia may beat last year’s record in 2014, as the Government provides tax incentives to get more people to use Syariah-compliant borrowing.
Islamic mortgages are found to have increased by 30% in 2013 to an unprecedented RM61.9bil, as shown in Bank Negara’s data. On the other hand, conventional home financing did not increase in growth momentum, with 10% to RM271bil, the same pace as 2012.
Despite increases in take up, Islamic finance – which was only established some 30 years ago, is still very nascent compared to conventional finance.
In the years leading to 2020, home buyers may find Islamic property financing offers more attractive compared to conventional loan as there may be more government-introduced incentives to further push the products toward the right direction.