Choosing Between Islamic Home Financing & Conventional Home Loan

A couple of days ago, I received an email from a friend asking me the following question:

“I am trying to apply for a housing loan. Seems that Islamic financing has much better deal than the conventional. But not sure why so many people are not comfortable with it. You know the reason?”

It is a never-ending discussion of which loan or package is better either Islamic or Conventional loans. I tried to explain as best I could. The small part in answering whether to choose Islamic or Conventional is in the following answer to my friend.

First thing identify is which Islamic contract is it based on. Is it a 1) Musyarakah Mutanaqisah or 2) Bai Bithaman Ajil (BBA)? BBA works on a Selling Price that is fixed, while a Musyarakah Mutanaqisah may have a fixed price element built as a maximum cap but overall the total amount depends on the reference rate tied to the product (BLR or BFR).

To be honest, there are little difference between both the above account with a conventional account, in terms of calculation. It is all about perception and sometimes, too much information is not necessarily a good thing.

The major difference is that, for BBA (and most other Islamic financing products), there is a cap to the amount that you pay i.e. a selling price, which is calculated by:

 The instalment amount x the tenure (months) = Selling Price.

For example the instalment amount is RM1,375-77 for financing period of 20 years = RM330,185-91

This selling price is stated in the contract as the absolute amount to be paid, but in events of refinancing to another bank or early settlement, the amount to be settled is EXACTLY what you will pay in a conventional loan. Why people are not comfortable is that they see the commitment amount under BBA is RM330,185-91 compared to conventional commitment of RM200,000. They are not able to see the fixed profit portion of RM130,185-91.

Like I said, it is all about perception. If you take conventional loans, you will not be able to determine the actual amount of interest you are going to pay at the end of the tenure, because, there is no cap to the interest rate i.e. tied to BLR which will move with the market. What happens when BLR increases to 7%? The loan is stretched longer than 20 years and the amount of interest will definitely be more than RM130,185-91.

Another perception is that with regards to the early settlement. For conventional, when you early settle, you have to pay-off the balance outstanding + whatever penalty you incur for early settlement. If your principal balance outstanding is RM140,000 and penalty is RM10,000, the amount you pay is RM150,000. However, under BBA, the amount to settle is often confused with the outstanding  Selling Price, which includes the future profit. Actually, for early settlement, the BBA gives away REBATES on the selling price which is equivalent to future profit not realized, although this is not stated explicitly in the documents. In short, the settlement amount for BBA is ACTUALLY the principal balance outstanding which is the SAME as the amount under conventional loans. Lately, there is a contention on the issue of rebates in BBA where there is no clear “formula” for the amount of rebates given. But in the system, rebates = future unrealized profits, plain and simple.

It depends on what you are comfortable with. Islamic Banking financing gives more transparency i.e. more fixed information on the loan but sometimes, too much information scares people. Some people prefer to know the basic things i.e. loan amount, years and instalment amount. Others, want to find out actually how much profit they have to pay for their housing loans; Islamic Banking provides that.

Musyarakah Mutanaqisah tries to meet the two products halfway.

Otherwise, there is no significant difference in terms of product features except how the financing is being presented to the customer. Of course, there are more documents to sign under Islamic Banking, but that should be irrelevant to the decision. Just choose on the best features of the product, be it conventional or Islamic.

2 Comments (+add yours?)

  1. Junior
    Sep 21, 2010 @ 13:51:34

    hye..
    juz want 2 ask ur opinion about my case..

    im planning to finance my mum house to use some cash for running business.
    that house is buying cash by my mum and currently value around RM100k. so my planning is to hold that house at least 5 years before fully settlement and give back that house to my mum.

    my question is
    1- which loan are most suitable for me either conventional or islamic
    2- loan tenure (short or long term)
    3- daily rest or monthly rest interest
    4- lock in period
    5- how many different amount if im make a full settlement after 5 years between
    conventional or islamic loans

    many thanks to you

    Reply

    • The Hotspot
      Sep 23, 2010 @ 21:50:33

      Hi Junior

      Before I give any advice, I trust you have done your research and have thought about the business and the income from the business. If properly planned, the house can be a good source of capital that can benefit all parties.

      Looking at your plan to hold fully settle within 5 years, I would say it is a good plan, but maybe you should consider also the following:
      1. Between conventional and Islamic, I would prefer Islamic simply because a conventional loan usually have heavy penalties for default loans. If you are a very disciplined person, then conventional loans can also be beneficial for you. But seeing that is a business, sometimes payments are irregular and we can be late in payments. It is good to have a facility that allows some flexibility. Something like the Musharakah Mutanaqisah facility will also be useful, and I also like the Standard Chartered conventional loan, where you can re-draw amounts already paid.

      2. If you have a ready timeframe to pay-off, then stick to it. 5 years is a good period to pay off, you should be able to recover the capital. But you can also consider this scenario: Instead of 5 years, take a longer loan BUT keep on paying the 5 years instalment. This way, you will always be “instalment paid in advance” and during tough business times, you don’t have to make instalments because you can use up your “advance instalments”. For example, a 5 year loan at 6.5% will cost you monthly instalment of RM1,956 and a 7 year loan will cost you RM1,484 and 10 year loan RM1,135. Take a longer tenure but still pay RM1,956, which in effect will cause you to settle the loan in 5 years, but it also gives flexibility during the tough times.

      3. Daily rest is a double edge sword. If your payment is irregular from your business, stick to a monthly rest loan. If you are confident your income comes regularly and early in the month, choose daily rest.

      4. Lock in period should not matter if you dont intend to pay-off before the 5 years. But if you do, just compare the penalty amount.

      5. Difficult question to answer. You need your bank to calculate this for you, because packages and terms differ from bank to bank. I cannot calculate for you without more information.

      Good luck. Hope I have helped. Cheers

      Reply

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