Growing need for ‘pure’ bay bithaman ajil home financing

WHEN we talk about Islamic home financing, one may assert that the product is expensive, leading to a claim by him in that a conventional home loan is a good alternative. In practice, however, there are at least two reasons explaining why Islamic home financing is competitive rather than pricey.

Firstly, Islamic home financing no longer relies on a fixed pricing regime. Islamic banks have extended a variable rate of financing to price their mortgages. The variations of monthly payment serviced by a customer will reflect the market value instead of the historical one.

Secondly, Islamic banks offer a different profit rate from one another. Individuals must be ingenious enough to filter out banks which offer expensive rates and turn to banks which offer better rates for better long term repercussions.

Laymen typically argue that BBA home financing is costly. BBA stands for bay bithaman ajil - a deferred payment sale. Of course, in the past, BBA home financing is found to be expensive when the interest rate is low out of the fact that BBA home financing uses a fixed pricing regime throughout the financing period.

For instance, a BBA home financing rated at 8% is expensive when its peer’s rate is reduced from 8% to 6%, but the former is unchanged (still at 8%), making a person jump to the conclusion that Islamic home financing is expensive. Worse, it is generalised to capture all financing products of Islamic banking.

Today, however, it is not an issue since Islamic banks have used a variable rate of financing to avoid mismatched funding as well as for an enhanced competitiveness. The notion of this rate was first coined by Professor Dr Saiful Azhar Rosly in his brilliant article titled ‘Al-Bay’ Bithaman Ajil financing: Impacts on Islamic banking performance’ published by the Journal of Thunderbird International Business Review in 1999.

In 2003, the idea was introduced by Bank Negara Malaysia (BNM) for improved mortgage portfolios by Islamic banks for better assetliability management.

Thus, this week I draw your attention on concepts of pure BBA home financing. Three questions are in need of answers. Question #1 - What are Shariah principles used for pure BBA home financing? Question #2 - What is the modus operandi of pure BBA home financing? Question #3 - Is the pure BBA monthly instalment similar to the industry version?

There are at least 5 Shariah principles for mortgage transactions: Principle #1 - The prohibition of interest or riba. Pure BBA home financing considers selling price, buying price and monthly instalment. The pricing element used is profit rate instead of interest rate.

Principle #2 - Trade-based transaction. Pure BBA home financing is a trade-based business where tripartite relationships are explicitly met. An Islamic bank buys an identified house directly from a developer and sells it to a customer later.

Principle #3 - Prohibition of gharar. Clarity is found in pure BBA home financing. Terms and conditions are certain to allow a better flow of transparency between the transacting parties.

Principle # 4 - Risk taking. In the practice of pure BBA home financing, Islamic banks directly own a house that is to be sold to a customer later. The ownership risk is borne by the banks, not the customer.

Principle # 5 - No two sales in one transaction. This occurs since Islamic banks take ownership of the house first before it is sold to the customer where one agreement is involved.

Generally, pure BBA home financing has four stages. The transaction involves three parties, namely an Islamic bank, a developer and a customer. First, the customer identifies a house through the developer who is constructing the housing project. Typically, the customer will pay 10% of the house’s price as a commitment to buy while the rest is to be borne by the bank via financing.

Second, the customer informs the bank about the house. Subsequently, the bank buys the house directly from the developer at cost. Third, the bank sells the house to the customer at premium for profit in return. It is indeed a sale transaction.

Fourth, the customer buys the house from the bank at premium and pays the monthly instalment until the completion of the financing duration. The ownership is transferred from the bank to the customer once all instalments are made.

In terms of pricing, pure BBA home financing is also computed similarly to the existing BBA home financing products at Alliance Islamic Bank, Al-Rajhi Bank and Public Islamic Bank. To make it clearer, two assumptions are counted.

First, an Islamic bank’s profit taking according to Shafi’i sect should not exceed 1/3, or 34% of the market value to avoid ghabnu fahiysh. This means that if the price of XYZ is MYR10.00, therefore a seller can only sell it at MYR13.33. In contemporary practice, however, the existing BBA home financing is transacted beyond this requirement, which contributes to the claim by laymen that Islamic financing is expensive. In practice, it is done owing to competitiveness and cost factors and, more importantly, urf where a differentiated pricing is needed.

Second, the computation of selling price is similar with the current one used by the said three banks. For better illustration, assume Muhammad Nour Imran intends to buy a house which will cost him a price of MYR100K (10% deposit, N=20 years, 3% profit rate and no grace period). Present value of annuities is used. Hence, the selling price is MYR119,793, the profit earned by the bank is MYR29,793 and the monthly instalment is MYR499.

Furthermore, I believe that there are at least three issues why this facility is not in place: Issue #1 - Does an ownership risk lead to the rejection of pure BBA home financing? A bank is a true seller when it takes full ownership of a house before it is sold to a customer for a profit in return. A scholar like Abu-Backer (2002) argues that “to say Shariah bank or Islamic bank would not be appropriate since in the Quran it only permits trading activities and not financial activities as understood in the conventional sense”.

Issue #2 - Does a bank’s maslahah erode when it offers the facility? Practically, pure BBA home financing, however, captures both interest of the transacted parties, viz., the bank and the customer. Issue # 3 - Does pure BBA home financing meet the homebuyers’ investment purposes? Research is needed to comprehend this issue fully.

To sum it up, this write-up presents some basic information on pure BBA home financing. In fact, this facility meets maqasid al-Shariah. Pure BBA does not involve any elements of legal tricks where an Islamic bank’s direct involvement in the ownership of a house is taken place before it is sold to the customer.

In the future, it is coveted that pure BBA home financing will be made available in the mortgage industry for better public acceptance and an Islamic bank’s profit where maslahah for both parties are overtly considered, at least.