Types of Islamic Loans / Financing
In Malaysia, there are 2 types of Islamic home loans. (Note: Some consider the use of the term “Islamic Home Loan” inaccurate. Firstly, Islamic Loans are benevolent loans that are interest / profit free. Secondly, contracts are technically not loans, but “Buy and Sell” or “Joint Partnership” agreements). The most common form is based on Bai Bithamin Ajil (BBA), which is itself a subset of the Murabahah concept. Less popular are facilities based on Musyarakah Mutanaqisah (MM).
The difference is as follows:
Cost plus profit mark up. Usually used to describe facilities with financing tenures less than 12 months and paid in a lump sum (E.g. Trade Financing). Sometimes used to describe BBA Islamic home financing products as well.
Cost plus profit mark up, paid over a deferred period of time. For housing loans, it means the bank buys the property and sells it to you at an agreed price (which includes the principal amount + profit) to be paid over X number of years.
Also known as Diminishing Musyarakah (DM). A partnership between bank and customer to buy the property. The bank leases the property back to you at an agreed rental amount (which includes principal repayment + profit component) and progressively decreases its shareholding over time. (E.g. Start with 90-10 ownership, after 10 years it become 60-40 ownership.
Determining the Profit
Regardless of the type of Islamic financing, it is necessary to determine the Profit Margin that banks stand to gain. There is no standard “Islamic” method for this. In most cases, bank’s calculate based on Conventional banking interest rate and amortization methods (except without compounding interest in overdue situation) and extrapolate back into terms acceptable to Islamic teachings.
For BBA/Murabahah, the profit margin is determined by a Fixed Profit Rate e.g. 10% p.a. which determines the Sale Price. The Sale Price divided by the number of months gives the Monthly Instalment. In its early days, Islamic Financing in Malaysia automatically meant Fixed Rate financing. However, they were not competitive against conventional Floating Rate loans.
Over time, Floating Rate BBA facilities were introduced. Since BBA facilities are Buy & Sell contracts based on an absolute Sale Price, a Rebate mechanism was introduced to emulate conventional Floating Rates. (Note: There are no standard “Islamic” formulas for calculating rebates. But operationally, most banks calculate rebates based on the difference between the Fixed Profit Rate and an Effective Profit Rate (EPR) to make it comparable to Conventional Floating Rate facilities e.g.:
BFR 6%-Spread 2% = EPR 4%.
Fixed Profit Rate 10% - EPR 4% = Rebate 6%
Additionally, the Fixed Profit Rate essentially became a Profit Rate Cap for which BBA facilities are now known for.
For MM, the profit is determined by the Rental Price. Again, operationally, banks base the pricing on comparable conventional banking calculations.
Choosing Between BBA and MM
Theoretically, between MM and BBA, due to the joint ownership concept, MM provides a better level of protection to the customer as any losses (E.g. Damage caused by natural disasters) are jointly owned. However, it may not be so in practice. As at this time of writing, there have not yet been any legal precedents.
The 2 major flavours of Islamic home financing in Malaysia are the BBA and MM genres. There are also differences between “Syariah based” and “Syariah compliant” products. Islamic home financing in Malaysia is generally of the “Syariah compliant” type. However, as with all things, Islamic banking products will continue to evolve. And Malaysia is at the forefront of this innovation.
To understand the advantages / disadvantages of Islamic vs Conventional Financing, go to this link. Islamic VS Conventional Financing.
To compare Islamic housing loans in Malaysia, use our Home Loan Comparison tool.