Question

ISLAMIC ACCOUNTING AND BANKING,, UNDERGRADUATE STUDENT

Assume Mr. Rauf enters into a Housing Finance with an Islamic Bank under Diminishing Musharaka Contract. The total value of the house id OMR 1000000 where Mr. Rauf provides 30% down payment and the balance 70% is invested by the bank. Rental value of OMR 10000 per year is agreed by both parties. The bank's investment of OMR 700000 will be bought by the Mr. Messi in 10 years in 10 equal instalments.

1. Explain what is diminishing Musharaka contract based on a home financing product and how it differs from the conventional home financing product.                 
2. Calculate the annual payment Mr Messi will be paying to the Bank in each of the first five years. The value should show the share of rent and capital repayment separately.                                                                                                                    
3. What are the features of an Islamic current account. Compare and contrast with a conventional current account.

Answer 1

Solution A

Diminishing Musharakah

As a participatory mode with profit-and-loss sharing Musharakah is considered to be the most desired mode of Islamic financing. And Diminishing Musharakah is now being used extensively in many areas for financing fixed assets such as houses and motor cars. It is used mostly when one party who wants to own an asset cannot afford to pay the full price and takes the assistance of financing from another party which ends up with the complete ownership of the asset by the first party who purchase the share of the other party over a period of time while at the same time complying with the rules of the Shariah. When used in home financing, Diminishing Musharakah can be viewed as a form of shared ownership with a leasing sale-back arrangement, which makes it different from an interest-based mortgage

DM arrangements allow equity participation and sharing of profits on a pro-rata basis, they also provide a method through which the bank keeps on reducing its equity in an asset against periodical payments, ultimately transferring ownership of the asset to the client. The procedure involved in Diminishing Musharakah is that the Islamic bank enters with a client into a partnership in which they both invest in the equity capital required to finance a project, and possibly also participate in the management; both share in the profits according to a pre-determined basis or in losses according to their investment. The bank would be also responsible for major maintenance, repair and insurance in respect of its share of a property. The client makes rental payments based on the level of equity held by the bank, with each payment, the bank’s equity reduces followed by a reduction in the rental calculated on the reducing equity. The client purchases the bank’s equity by the capital repayments, accordingly, its share is progressively increasing and the bank’s equity is diminishing until the bank has no equity and thus the client acquires complete ownership. Similarly, the rental payments keep reducing with the bank’s diminishing equity in the asset until no further rental payment has to be made.

Conventional Loan

A conventional mortgage or conventional loan is any type of home buyer’s loan that is not offered or secured by a government entity. Instead, conventional mortgages are available through private lenders, such as banks, credit unions, and mortgage companies.

How is Diminishing Musharakha is Different from Conventional Home Loan:

1. The contract of Diminishing Musharaka house financing can be effected for a future date on the condition that the “profit” rate is payable after possession of the house by the client. Thus an effective forward contract is allowed despite its prohibition in Islam. It is called “a later” contract by the Islamic bank. Repayment of principal and “profit” / rent becomes due on possession of property by the client. While The contract of conventional house financing can be effected from the first day of the agreement without the client’s possession of the property

2. If the financier contravenes any term of the agreement, the client has the right to terminate the Musharaka contract unilaterally. If there is no contravention on the part of the financier, the contract cannot be terminated without mutual consent by the client. The bank can terminate the contract without mutual consent, if the client does not pay “profit” on time, and he is not able to buy the shares of the bank according to schedule.

However, in Conventional Hosing Loan Product The client can terminate the contract unilaterally if the bank contravenes any terms of the contract. The bank also has right to terminate the contract unilaterally, if the client contravenes any terms of the contract. Without mutual consent the bank can also terminate the contract, if the borrower is not able to pay interest with principal according to payment schedule.

3. In the Diminishing Musharaka house financing contract the financier as a Shirkat-ul-Milk participates in “profit” not in loss, the client will participate in both “profit” and loss, and the client will bear all losses.

In the conventional house financing contract, there is no “profit and loss” agreement between the bank and the client. The client suffers losses. Losses can occur due to improper location, insufficient material employed in building, other technical problems and improper care.

4. In the Diminishing Musharaka house financing contract the bank and the client co-own the house according to a predetermined ratio, if the bank invests 80% and the client invests 20%, the bank will own 80% of the property.

In a conventional house financing contract, the client has ownership, but his property papers remain in the bank until after paying of all scheduled amounts. Conventional banks prefer simple and registered mortgages.

5. In Diminishing Musharaka house financing contracts, the client and the bank jointly buy the house on the basis of a debt equity ratio, usually (80:20 or 60:40). The bank divides its equity shares into equal units. The bank makes an agreement to allow the client to buy the units periodically, thus reducing the share of the bank and increasing the share of the client. This arrangement allows the bank to claim “rent” according to its proportion of ownership in the property and at the same time allows a periodical return of a part of the principal through purchase of the units of the bank’s share of the house by the client.

In conventional house financing contract, the client is the sole owner of the property, the bank has the mortgage deed of the client’s property. The bank divides its loan into equal instalments with fixed interest rate. Thus the client pays principal plus interest periodically. After completion of instalments in the required period, the bank releases the mortgaged documents to the client.