By Basheer Oshodi
A unique aspect of non-interest finance is its ability to innovate within the confines of partnership, sale and lease contracts. While partnership is basically a joint venture arrangement where parties pool resources, share risks as well as benefits as agreed, diminishing partnership on the other hand, has two sides – the partnership bit and the leasing angle.
In the beginning, in the United Kingdom, those who offered diminishing partnership services started off by offering mortgages on the basis of sale contracts, i.e. they would buy the house from the seller and sell it back to the customer. Like many non-interest finance contracts, the seller would have an undertaking to buy back the asset from the bank. And since mortgages in the United Kingdom are usually long term, non-interest financial institutions ordinarily would not review the agreed mark-up even where the buyer defaults. Many times, the buyer would pay much more when using sale for such long-term transactions. A shift became necessary from the use of sale to lease mode of financing mortgages. A lease allows either fixed or variable rental repayment. In the case of varied rental repayment, the ceiling and floor for such rentals must be agreed on in the contract terms from inception and such would ordinarily not be reviewed after sign off. Early repayment is allowed in non-interest finance and there would be no penalty for it. Unlike a sale with fixed mark-up regardless of early repayment, a lease allows the lessee to increase his or her contribution which would further reduce outstanding facility. The financial institution also maintains ownership of the asset in a lease mode.
The United Kingdom mortgage system under Islamic finance quickly moved to the diminishing partnership (musharakah) mode where both financial institution and customers have certain percentage of ownership in the asset on day one while the customer would be paying rent on the part that the bank owns. This payment reduces gradually as the customer takes more ownership in the asset until such a time where the bank no longer has equity in the property and the customer can take ownership of the house. Practically, amortisation under diminishing partnership looks so much like the conventional banking reducing balance amortisation except that default pricing on the entire facility is not allowed. Unlike sale and lease contracts, amortisation is usually based on equal repayment. Scholars opine that amortisation is mainly a business decision rather than a Shariah one. They are therefore in agreement that a sale, and even a lease may also be based on reducing balance.
- There are two sides to diminishing partnership: the partnership bit and the leasing angle.
- A lease allows either fixed or variable rental repayment.
- Sale is usually cheaper for the customer where transaction is very short.
- Unlike sale and lease contracts, amortisation is usually based on equal repayment.
- In a sale, the ownership of asset lies with the customer and non-repayment means that such debt needs to be repaid.
It is glaring from simple calculation that a sale is cheaper for the customer where the transaction is very short. Thus, the longer a sale (murabaha) transaction, the more money the customer will pay to the bank. In the same vein, the longer a sale transaction, the cheaper it becomes for the customer in terms of total repayment under a reducing balance amortisation regime. Using sale contract for a 15 year mortgage becomes much more expensive for the customer than using a lease or a diminishing partnership. However, using the sale contract for a one year mortgage would usually be cheaper than lease or diminishing partnership contract where the mark-up rate is fixed at same amount for both approaches.
Default on the side of the customer under a lease means that the customer is not paying rent as at when due and may be asked to vacate the premises. In a sale, the ownership of the asset lies with the customer and non-repayment means that such debt needs to be repaid. The bank may foreclose after considering some extension depending on the financial status of the customer. In a diminishing partnership, default is treated in a rather friendly manner. Thus, when a customer is unable to pay rent, the bank may sell off the asset, take its remaining part of the partnership and give the customer his or her own partnership part of the property. Increase or decrease of property prices at foreclosure is borne by the bank and customer in proportion of their existing equity in the asset.