Borrowing is still possible when interest is banned by religious law
By Holden Lewis • Bankrate.com

Nadeem Haq figures that he has paid enough rent in the past 20 years to have bought several houses by now.

He didn't have much choice -- as an observant Muslim, he takes seriously Islam's prohibition against paying or receiving interest. That rules out a conventional mortgage.

Two years ago, the Silicon Valley telecommunications engineer bought a house using interest-free financing, thanks to one of the country's few funding sources that adhere to Islamic law.

In essence, he is renting to own -- and he plans to own the house outright in about a year.

Haq belongs to Ameen Housing Co-op, a kind of limited partnership comprising about 200 Muslims living in and around Palo Alto, Calif. In the cooperative's four years of existence, 12 families have bought houses with its help.

How it works The following example is an oversimplification, but will illustrate the concept:

Let's say you buy a house for $100,000 and make a $20,000 down payment. The lender (be it a finance company or a cooperative) owns 80 percent and you own 20 percent. If the rental value is $1,000 a month, you pay that amount, plus an extra sum (let's say $300 a month). With your first payment, $800 would go to the lender (80 percent of the rent because the lender holds 80 percent of the value of the property) and $500 would be applied toward your equity ($200 rent for the 20 percent stake you have in the property, plus the $300 extra). With each monthly payment, your equity increases and the lender's share of ownership decreases, just as they do with a regular mortgage. The difference is that the lender in an Islamic-style loan does not enjoy a guaranteed rate of return; instead, the profitability of the loan is affected by changes in the housing and rental markets. Payment amounts can be changed periodically to reflect fluctuations in the rental market. Islamic lenders encourage borrowers to repay as quickly as they can.

"Given that we don't have too many options to buy the house in an interest-free way, this was actually a very pleasant experience for me personally," Haq says. "The only issue with Ameen Housing Co-op is that they don't have enough money to go around for a big backlog of people who are awaiting houses. I was fortunate to be one of the early ones."

The quicker he pays off his loan, the quicker another member of the co-op can move up in the waiting list and buy a house.

Sharing the investment
Islam is the fastest-growing religion in the United States, with an estimated 5 million to 10 million adherents. Its tenets strictly ban interest. Instead, lenders are supposed to invest in their clients' ventures and share in the profit or loss. For observant Muslims in the United States, the ban on interest makes it tough to buy a car and almost impossible to buy a house.

A few institutions have stepped into this void, creating rent-to-own and lease agreements that satisfy religious law, homeowners, car buyers and even the Internal Revenue Service.

There's Ameen, which as a cooperative shares its profits and losses among its member investors. There's American Finance House - LARIBA, a finance lender based in Pasadena, Calif. A pioneer in interest-free financing for Muslims was Al Manzil, a New York-based subsidiary of the Bank of Kuwait, which is withdrawing from the U.S. market.

"The key difference between this and a traditional mortgage is how the rate of return is calculated," says Mike Maguid Abdelaaty, president of American Finance House - LARIBA. In a conventional mortgage, the rate of return is the interest rate. In an interest-free transaction that complies with Islamic law, "the rate of return is based on the rental value of the home you are trying to buy."

Different, with similarities
All Islamic financing, whether the item being bought is a house, vehicle or business equipment, follows this rental model. The lender buys the property. The buyer then pays the lender the market monthly rental value, plus an amount over that. The extra money and part of the rent go toward buying out the lender's share in the property. Eventually, the buyer owns the item outright.

From the buyer's perspective, the arrangement doesn't differ all that much from a conventional mortgage: there are the monthly payments, the paying down of the loan. From the lender's perspective, Islamic financing carries more risk because the arrangement is a joint investment. If the buyer decides to sell the property before paying off the loan, the lender shares in the profit or loss.

A trained person with a calculator can figure the "imputed interest" -- what the buyer pays in the equivalent of interest. When you run the numbers, this kind of financing costs a little more than conventional loans, Abdelaaty says. Usually the imputed rate is about 0.5 percent to 0.75 percent more.

Borrowers have been able to report the imputed interest on their taxes. The IRS accepts the deduction, say officials from American Finance and Ameen Housing Co-op. Humayun Sohel, secretary of the Ameen board, says some borrowers don't take the deduction because they want to steer clear of any hint of paying interest.

These financing contracts are usually for a shorter period than conventional loans. Ameen loan papers usually cite a repayment period of 10 years, but the co-op's members are mainly Silicon Valley engineers who receive large bonuses and options, so they typically repay the loans in three years. American Finance House's customers pay off their loans in an average of six years.

Terminology

About half of Islamic borrowers are immigrants and half were born in the United States. They come from a variety of backgrounds: African-American, Arab, Pakistani and Iranian are among the most common. All share a common tongue, Arabic, in religious matters.

Sharia: Islamic religious law. Halal: Permitted for Muslims under Sharia. Haram: Not permitted for Muslims under Sharia. Riba: Interest. Riba is haram. Ijara wa iqtina: Rent to own, usually of a house.

Demand exceeds supply
Abdelaaty says the market is just beginning to be tapped.

"The demand far exceeds the supply of financing, definitely," he says. "Our estimates are that there's at least a billion dollars of financing volume out there and no company has even approached 10 percent of that yet."

Islamic lenders primarily are held back by funding sources, he says: American Finance isn't a bank, so it can't raise deposits. The same goes for its few competitors, the most prominent of which is Houston-based MSI Financial Service Corp.

These kinds of loans aren't available only to Muslims. American Finance has lent money to non-Muslims. So far, only Muslims have bought houses through Ameen, Sohel says, but he believes Islamic-style financing might appeal to people of all faiths, especially in rural areas where property values aren't appreciating rapidly.

"If the message is taken to them, it might be accepted," he says.

Haq, the man who is buying his house through Ameen, agrees: "The idea has a lot of merit, even if I weren't a Muslim."