The lexical meaning of ‘Diminishing Musharakah’ is ‘Declining Balance Partnership’, this is the Arabic term used to define the Home Purchase Plan (HPP) offered by many Islamic Banks. The client of the Islamic Bank plays two roles, he/she is both the partner and tenant of the bank. This is seen as an alternative mode of financing a house purchase as the bank does not passively lend to its client, rather, it engages in an active partnership with it’s client to share the risks & returns. The ‘Diminishing Musharakah’ product consists of 2 separate/distinct contracts operating under one product, which are the ‘Musharaka’ and ‘Ijara’ contracts.
The ‘Musharaka’ (partnership) component involves a down payment of a fixed amount by the client and the remaining value is advanced by the bank. The funds are combined to purchase the house under the ownership (title deed) of the bank. The bank agrees with the client to defer the principal payment over a specified period (such as 25 years). The bank calculates the principle payments by using the formula loan value/no of months; this constitutes the division of the property into equal number of units. The second contract in action is the ‘Ijara’ (leasing/rental) that involves the client making routine interval payments as rent for occupying the property. The client assumes all administration expenses attached to the house as he/she is the ‘occupying’ partner of the house. The payments made by the client to the bank are calculated using the following formula: rent amount + principle payments. The rent component is theoretically ‘split’ pro rata according to proportionate ownership. In practice, this manifests itself through discount applied to payments; the client is simply renting the bankers share. In simple words, the monthly payments made by the client involves the purchasing of ‘units’ from the bank and the renting of the remaining ‘units’ owned by the bank. There is a periodic readjustment of the rent to reflect the proportionate gain in share of the property by the client. At maturity (on final payment) the client buys the ‘last unit’ of the property to own 100% of the house, whilst the bank recovers it’s initial investment and has its share reduced to 0%, this invokes the transfer of the title deed to the client.
An example will be used to explain the above points. A client approaches an Islamic Bank with a deposit of £20,000 to finance the purchase of a house that is valued at £100,000. The bank provides the remaining £80,000 to finalise the purchase of the house. From the onset of the contract the client’s share equates to 20% and the bank’s share equates to 80%. The client agrees to pay the principle amount of £80,000.00 on a deferred basis spread over monthly intervals for 25 years, this is termed monthly acquisition payments. The property is split into units according to the above formula, meaning £80,000/300 is the value of each unit. The second contract involves the client paying rent on the banker’s share, this is calculated according to a formula set out by the bank (which differs across banks). The client’s monthly payments = £80,000/300 + rent. Once again, on the 300th payment the client takes outright ownership of the property and the title deed is transferred to the client.
From the face of it the HPP seems to be similar to a conventional mortgage, HPP has fixed component (LV/No of Months) plus an agreed rental payment (can be fixed or varied); the fixed component to some may resemble the interest rates on conventional borrowing. How then does it differ? Conventional mortgage is based on the idea that the client is loaned the lump sum amount to purchase the house in his/her name, thus the client retains not only the rights to the property but also the risks of the property. If the client fails routine payments, the bank is legally allowed to repossess the house to sell and recover the debt. The client does not share in the proceeds from the repossessed sale of the property. Under the HPP however, the same situation would result in the proceeds from the sale being shared between the client and the bank according to their share of ownership. Additionally, HPP contracts often provide more than one contingencies in the event of default by the borrower; repossessed sale is likely to be a last resort by the bank. HPP allows the bank to amend the ownership share to reflect the client’s past due payments. Another main difference between the HPP and a conventional mortgage is that of an ‘exit penalty’. If a client wishes to pay the mortgage off early, he/she will be charged an ‘exit’ penalty to compensate the bank for the early termination of the agreement and loss in the future mortgage payments. Under the HPP, the client cannot be punished for buying out the other partner (i.e. the bank), what is allowed is reasonable administration expenses such as legal fees.
To sum up, the main feature of a ‘Diminishing Musharaka’ contract is that it is a partnership based endeavor between the bank and its client. The interest of the bank and the client is thus aligned, both parties wish to see the venture succeed and to avoid any potential loss. It is hoped and indeed plausible to assume that such an alignment of interests would promote responsible lending by the bank.
Financial Conduct Authority (FCA). Home purchase plans. 2013. http://www.fca.org.uk/firms/financial-services-products/mortgages/home-purchase-plans (accessed January 28, 2014).
Hussain, Dr A. Islamic Mortgages.co.uk: Islamic Home Financing and Mortgages. 2006. http://www.islamicmortgages.co.uk/index.php?id=277 (accessed January 28, 2014).
Islamic Bank of Britain (IBB). Home Purchase Plan. 2014. http://www.islamic-bank.com/home-finance/home-purchase-plan/ (accessed January 28, 2014).