What do you do if you want to buy a home or borrow money for your
business but your religion prohibits you from paying interest?
Millions of Muslims in the United States face that question. A
set of Islamic principles—based on the goal of providing economic
justice for all—prohibits Muslims from paying or receiving interest
during financial transactions. Some Jewish and Christian groups
face a similar prohibition. Since the financial-services industry
in the United States is interest-based, there is great demand among
Muslims and certain other faith-based populations for alternative
financial products that provide access to credit in a manner consistent
with their religious beliefs.
In the Twin Cities and surrounding communities, demand for alternative-financing
products is high due to the rapid growth of the area's Muslim population—growth
that is driven primarily by a recent influx of Somali immigrants.
The size of the Muslim population is difficult to determine accurately,
but the market created by recent arrivals from Somalia and Muslims
already living in the Twin Cities could be as large as 130,000 people.
(For more information on the difficulty of determining the size
of the area's Muslim population, see our feature
A number of key factors intensify demand for alternative financing
in the Twin Cities. First, the area has few rental properties that
are large enough to comfortably accommodate families. Many Muslims
must purchase single-family homes to meet their families' needs,
and they face difficulty in obtaining mortgage financing that is
consistent with their religious beliefs. Second, the many Somali
and other East African immigrants in the Twin Cities are often low-
to moderate-income, so it is difficult for them to make large cash
purchases or down payments without relying on conventional debt-financing
mechanisms. And finally, after they finance small business start
ups through modest cash gifts and equity investments from family
and friends, these individuals may need large amounts of working
capital, but often have a difficult time finding credit products
that are consistent with their religious beliefs.
These issues came to the attention of the Federal Reserve Bank
of Minneapolis in the late 1990s, when local and state housing agencies
noted a sharp increase in public requests for information about
alternative mortgage products. In May 2000, the U.S. Department
of Housing and Urban Development, in cooperation with the Federal
Reserve Bank of Minneapolis and other organizations, including the
Minneapolis Foundation, the Family Housing Fund, Islamic Relief
and Social Services, Somali Community in Minnesota and Northside
Residents Redevelopment Council, organized a seminar on mortgage
financing for Muslim homebuyers. The event sparked interest in creating
lending alternatives for Muslims and other interest-averse groups
living in the Twin Cities area.
In 2001, the Minneapolis Fed convened a work group to explore Islamic
finance, alternatives to interest-based lending and related issues.
Partners in the initiative include local, state and federal government
agencies; banks and credit unions; community development corporations;
secondary market investors and Islamic and Somali community organizations.
Members of the work group have gained considerable experience with
alternative-lending issues over the past year and now want to share
their findings to help educate lenders and community development
professionals in the Ninth District and across the nation. This
- Provides a brief explanation of Islamic-financing principles;
- Summarizes mortgage and small business lending issues explored
by the work group;
- Presents various alternative-financing models identified through
this initiative; and
- Recaps outcomes of the Twin Cities initiative.
Fundamentals of Islamic financing
Wafiq Fannoun, president of Reba Free, LLC, an Islamic financial-
and investment-consulting service, explains the fundamental principles
of Islamic finance as follows:
Islam's aim from any financial transaction is to maintain
economic justice between those who have and those who have not.
It is essential in Islam that all parties involved in a financial
transaction share the actual profit or loss of a venture, and
that no one gets predetermined compensation such as interest.
In effect, the Islamic system functions much like western equity
financing, while protecting borrowers from leveraging themselves
into the poorhouse. 1/
According to the Holy Qu'ran, which Muslims consider to be the
word of God through the Prophet Mohammed, trade and profit on business
transactions are permitted as long as those involved share the risk
and maintain economic justice for all participants. Islamic law,
or shari'ah, set out in the Qu'ran prohibits riba or
reba, translated from Arabic as "interest on a debt or
loan, or any risk-free return on capital."
Islamic law allows for alternative forms and techniques of financing
with a moderate rate of return. It simply prohibits the receipt
or payment of interest as a means of determining that return or
profit. Therefore, while Muslims cannot pay or earn interest, they
can pay and earn a profit.
In other words, financing for Muslims must be structured without
interest, but can include a profit to the lender. This seeming paradox
makes it difficult for some American lenders to understand the distinction
between profit-based, non-interest financing and interest-free or
no-interest financing. Islamic financing is not no-cost financing.
The profit to the lender in Islamic financing is simply structured
in alternative ways that do not rely on interest but do involve
shared risk in the lending transaction.
Islamic financing and American banking: Key issues
The application of Islamic principles to American financial practices
raises many complex issues. The receipt and payment of interest
is just one of those issues. The sections below explore other issues
that further complicate lending to interest-averse communities.
They also highlight models that address the issues—or explain why
a particular issue is difficult to overcome. In those cases, non-bank
intermediaries can often fill gaps that regulated financial institutions
Asset ownership and risk sharing
Islamic financing is not based solely on the prohibition of riba.
Islam outlines additional principles pertaining to the ownership
of assets and the sharing of risk. Importantly, followers of Islam
believe that in order to sell an asset, one must own it outright.
This concept, referred to as murabahain Arabic, protects
buyers from purchasing a good that is not actually available for
sale by the true owner or seller. Islamic law also states that a
fair business transaction requires all parties to share the risk
involved. Thus, if a lender acts as a third party in financing a
buyer's purchase of an asset from a seller, the action is deemed
unacceptable under Islamic law unless the lender directly purchases
the asset and owns it outright. These principles govern any financial
transaction that Muslims engage in, and they have clear implications
for lenders, especially government-regulated financial institutions.
In most cases, U.S. banking regulations prohibit financial institutions
from purchasing and holding real estate for mortgage transactions.
The National Bank Act includes restrictions on the ability of nationally
chartered banks to hold real estate. The restrictions " . .
. are intended to: (1) keep the capital of banks flowing into the
daily channels of commerce; (2) deter banks from embarking on hazardous
real estate speculations; and (3) prevent banks from accumulating
and holding large masses of real estate in perpetuity." 2/
State laws impose similar restrictions on state-chartered banks.
In compliance with these rules, domestic banks typically finance
customers' home purchases by using properties as collateral instead
of actually holding title until the loan is paid in full. The transfer
of property is a direct transaction between the homebuyer and the
seller. Under this transaction, the lender never actually purchases
the property for resale to a buyer, does not have an equity-ownership
position in the home and does not share risk in equal amounts with
A number of mortgage-financing models have emerged that not only
include profit-based repayment terms, but also address the issues
of asset ownership and risk sharing. Many of the entities offering
these products are not subject to banking regulations, which allows
them greater flexibility in developing models that are acceptable
under Islamic law.
For example, Hennepin County, Minnesota, offers an alternative-financing
program for the purchase of tax-forfeiture property. In certain
cases, properties revert to the county's ownership through the State
of Minnesota's tax-forfeiture process. The county can then sell
these properties, through public auctions, directly to interest-averse
homebuyers and other individuals. The county is able to do this
because it is not restricted from owning and holding real estate
for lengthy terms. (For more information on the county's program,
see the box below.)
Hennepin County alternative financing
Hennepin County is the largest metropolitan county government
in Minnesota, encompassing Minneapolis and several other communities.
When a property in one of those communities goes into tax
forfeiture, its ownership reverts to the state, in trust for
the local taxing districts. The county administers these tax-forfeited
properties, and, following the statutory public-auction process,
can sell them on an annual or semiannual basis.
Financing the sale of these properties to interest-averse
populations was an obstacle. To address the problem, the county
developed an alternative-financing contract. The contract
and its supporting documents are based on a model of monthly
installment payments over a negotiated term, typically five
or ten years on a contract for deed.
A typical transaction works like this: the property is sold
at auction to the highest bidder, but not for less than the
appraised-value minimum-bid price. If the buyer decides to
use the alternative-financing contract, he or she agrees to
regular, fixed installments that are calculated by marking
up the purchase price no more than 14 percent. The 14 percent
markup is considered the county's profit on the property sale,
not interest earned. According to state law, the interest
rate on tax-forfeited property is adjusted annually, based
on market rates, and must fall between 10 and 14 percent.
To ensure that the county is not underpaid, the 14 percent
rate is the implied interest rate. Buyers then pay fixed monthly
installments to the county. The county converts the monthly
payment amount to an interest-based-equivalent payment and
then pays the county treasurer an amount equal to the principal
and interest owed to the state. The state bases the interest
rate on the fluctuating market rate, as established by state
law. In the event that the state charges less than 14 percent
interest during a given year for tax-forfeited properties,
the county calculates the amount equivalent to the interest
that buyers have overpaid throughout the year and refunds
them the difference.
The benefits of the county program are threefold. First,
it closely adheres to the Islamic principles requiring direct
asset ownership and non-interest financing. Second, the program
enlarges the pool of prospective residential real estate purchasers
and thus enables the county to return tax-forfeited properties
to private ownership, which increases the property-tax base.
Finally, the alternative-financing contract and documents
establish a replicable model that can be used across the country.
American Finance House LARIBA (LARIBA), a private finance and mortgage
company, offers another alternative mortgage product. LARIBA ensures
that risk is shared equally among all parties by structuring home
financing under a conceptual partnership model that involves a decreasing-equity
position for the company. LARIBA and the buyer jointly purchase
the property, with the buyer providing a down payment and LARIBA
providing an equity investment in the home. As the buyer makes monthly
payments to LARIBA at a markup, the buyer's equity in the home increases
and LARIBA's equity decreases until, at the end of the financing
term, the buyer owns 100 percent of the home. (For more information
on LARIBA, see the box below.)
American Finance House LARIBA
American Finance House LARIBA (LARIBA) is a Web-based finance
and mortgage company in Pasadena, California, that is licensed
to finance home purchases in 25 states, including Minnesota.
LARIBA developed a financing model based on ijara-wa-iqtina
(lease-purchase) transactions, in which the company and the
homebuyer enter into a conceptual joint lease-purchase agreement,
with LARIBA providing the capital for the portion of the purchase
price that is not covered by the buyer's down payment. To
pay off the balance, the buyer agrees to make monthly lease
payments to LARIBA for its share of the property. Despite
the fact that the property is purchased jointly by LARIBA
and the homebuyer, title transfers directly to the homebuyer
at the point of sale.
Once a Muslim buyer selects a property, LARIBA and the buyer
each consult with three different local real estate agents
to determine what the property's fair-market rent would be.
Using these six independent rent estimates as a base, LARIBA
calculates a fixed monthly payment. The buyer's monthly payment
covers repayment of capital, which decreases LARIBA's equity
share in the property while increasing the buyer's share.
It also includes a return on capital, which is calculated
according to LARIBA's share in the rent, proportionate to
its total share in the venture. LARIBA ultimately determines
the imputed interest rate in order to comply with regulations
such as the Truth in Lending Act.
In the past, LARIBA lacked the necessary capital to finance
a large volume of home purchases. In 2001, LARIBA began working
with Freddie Mac, one of the largest secondary mortgage market
investors in the country, to recapitalize its loan fund. Under
the LARIBA-Freddie Mac partnership, customers sign traditional
Freddie Mac mortgage documents and a patented LARIBA agreement—a
rider—explaining that, despite references to interest in the
standard loan documents, the loan is structured in a manner
that does not include interest.
For more information on LARIBA, visit www.lariba.com.
Despite the limitations of domestic banking laws, regulated financial
institutions are beginning to develop alternative products that
are acceptable to interest-averse populations. HSBC Mortgage Corporation
(USA), or HSBC Mortgage, in New York now offers a murabaha
product to address the issue of asset ownership. HSBC Mortgage is
a wholly owned subsidiary of HSBC Bank USA, a New York bank that
is regulated by the New York State Banking Department and the Federal
Reserve System. In November 1999, the Office of the Comptroller
of the Currency issued Interpretive Letter #867in response
to a request from the United Bank of Kuwait. The letter states that
it is permissible for national banks to offer murabaha financing
products ". . . to help Islamic customers engage in real estate
financing transactions and commercial inventory and equipment financing
HSBC Mortgage is thus able to employ the murabahamodel
in purchasing a home from the seller and then, subsequently, selling
it to a Muslim buyer. This model does not fully address equal risk
sharing, and HSBC Mortgage is finding that many customers actually
prefer an ijara-wa-iqtina, or "lease-purchase,"
arrangement, to a murabaha, or "buy-sell," agreement,
because the ijara-wa-iqtinamodel satisfies both risk-equity
and asset-ownership principles of Islam. (For more information on
HSBC Mortgage, see the box below.)
HSBC Mortgage Corporation (USA)
HSBC Group serves customers around the world. Its global
presence has led it to develop products for international
markets, such as the Middle East, where some consumers lack
previous exposure to U.S. banks. The company houses a group
in Dubai, focused solely on Islamic finance issues, to serve
its Middle Eastern customers. As these issues gain visibility
in the United States, HSBC Mortgage Corporation (USA), or
HSBC Mortgage, has tapped into this existing knowledge base
to develop a domestic product that adheres to Islamic principles.
After a lengthy product-development process, HSBC Mortgage
rolled out a riba-free mortgage product in the state
of New York in March 2002. The product is based on the murabaha
(buy-sell) model, in which the customer identifies a property
and negotiates the purchase price with the seller. During
negotiations, the customer presents the seller with a document
explaining that HSBC Mortgage will actually be buying the
property from the seller. A closing takes place at the point
of sale, with HSBC Mortgage buying the property from the seller
and immediately reselling it to the homebuyer. Despite making
the initial home purchase, HSBC Mortgage does not take title
to the home at any point and is exempt from any state transfer
To finance the sale of the home, customers are eligible for
fixed-profit financing with terms of up to 30 years. The financing
operates like a conventional bank loan and HSBC Mortgage offers
flexible terms such as low down payments and the use of nontraditional
credit for underwriting purposes. Buyers make installment
payments that equal a portion of the purchase price, plus
HSBC Mortgage's profit margin. HSBC Mortgage escrows a portion
of the payment for taxes, and any interest earned on the escrow
account is donated annually to a charity. The customer receives
a Form 1098 from the Internal Revenue Service for the mortgage-interest
deduction, but it is his or her personal decision whether
or not to claim a tax deduction.
The bank has closed four loans to date, and it hopes to introduce
its Islamic-financing product to other parts of the United
States in the future.
For more information on HSBC Mortgage and its riba-free
mortgage product, visit www.amanahfinance.hsbc.com.
These issues can be less complex for small business financing,
due to the nature of small business transactions. The type of asset
being financed by a small business owner—typically a commercial
building or piece of equipment—lends itself to lease-purchase or
markup-and-installment arrangements for shorter terms than those
required in housing transactions. However, complexities arise when
businesses require start-up or working capital.
The Neighborhood Development Center (NDC), a community development
corporation serving the Twin Cities, offers several transaction
models to address the issues of asset ownership and risk sharing
in small business finance. The first model involves a murabaha
(buy-sell) transaction, in which the NDC purchases an asset directly
from a seller and then sells the asset to the buyer at a negotiated
price. The NDC receives a 10 percent profit and signs an installment
payment plan with the buyer for a negotiated term of up to five
A second model employed by the NDC is a lease agreement with an
option to purchase, structured with monthly payments. This ijara
(lease-purchase) model works well for equipment purchases by small
Another model used by the NDC, which illustrates the risk-sharing
principle, follows a royalty-investment structure. The NDC makes
an investment in the business, the business owner provides owner
equity, and then both share in any profits or losses over a given
period. The amount of capital provided by the business owner is
negotiable, but typically falls within the range of 5-10 percent.
Working capital loans are also available under this model but typically
are in small dollar amounts due to the increased risk involved.
(For more information on the NDC, see the box below.)
Neighborhood Development Center small business financing
The Neighborhood Development Center (NDC) is a nonprofit
community development corporation located in St. Paul, Minnesota.
It offers business training, loans and technical assistance
to help inner-city residents revitalize their neighborhoods.
In partnership with 18 community groups, the NDC has helped
nearly 400 entrepreneurs open businesses since 1993.
The NDC provides Islamic financing to Muslims and non-Muslims
alike in target neighborhoods throughout the cities of Minneapolis
and St. Paul. Target neighborhoods include low-to-moderate
income areas, where residents earn 80 percent or less of the
1999 area median income. The NDC also considers applications
for business assistance if the applicant demonstrates a high
degree of community impact.
Alternative forms of financing available through the NDC
in accordance with Islamic law include:
- Buy-sell agreements with deferred payment terms whereby
the NDC will purchase the asset and then sell it at a profit
to the business owner.
- Lease-purchase agreements, in which the NDC will purchase
the asset, then sign a lease agreement with the business
owner that includes an option to purchase the asset.
- Royalty investments, where the NDC will contribute capital
to a specific project or deal, sharing the profit or loss
from the transaction with the business owner.
- Interest-free loans, which are only available in conjunction
with one of the other financing options listed above and
can be used to finance small amounts of working capital.
Loan availability depends on the size of NDC's Islamic-financing
The NDC offers alternative-financing deals ranging from $500
to $30,000, depending on the nature and size of the business
enterprise and the availability of funds. NDC assistance may
be used to finance items such as office and production equipment,
office furniture and computers, short- and long-term assets,
inventory, leasehold improvements and working capital. Terms
are typically from six months to five years, depending on
the amount of financing and the needs of the business. The
NDC's finance committee reviews all applications.
For more information about the NDC, visit www.windndc.org
or call (651) 291-2480 or (612) 501-5122.
Documentation and accounting
As previously discussed, Western financial institutions must comply
with banking regulations and follow standard accounting practices.
These conventions can make even slight deviations from interest-based
products very difficult to accommodate. Most financial institutions
in the United States use standard mortgage documents that adhere
closely to banking and consumer compliance laws. These forms and
documents were designed for interest-based loan products. As such,
they contain terms and conditions specific to interest. Standardized
loan documentation is used not only to streamline loan processing
and help lenders maintain compliance with laws and regulations,
but also to make the process of packaging and selling loans to secondary
market investors straightforward.
Lenders and financial institutions face significant challenges
when altering standard loan documents to reflect terms and conditions
that are not based on interest. Complex loan-processing and information-technology
systems make it challenging for financial institutions, especially
large ones, to manage loan products and documents that deviate from
A partnership between LARIBA and Freddie Mac, a major investor
in the secondary mortgage market, attempts to address the documentation
issue. The partners developed a program that allows Muslim homebuyers
to use standard Freddie Mac loan documents. When buyers sign those
standard documents, they also sign a patented LARIBA agreement consisting
of a rider that replaces interest-related terminology with language
related to markups and installments.
Accounting issues may seem minor in comparison to the other issues
discussed here, but they can be just as challenging. The primary
accounting issue pertains to the value of an asset before, during
and after a transaction. If a lender purchases an asset at a certain
price, marks up the price to make a profit and then sells the asset
to a Muslim buyer, which price—the original selling price or the
higher, profit-based price—should be recorded on the lender's books?
This matter is complicated further if the lender wishes to sell
these loans on the secondary market.
For many Muslims, Islam is a way of life, defined by the Qu'ran
and the Hadeeth, or the examples and sayings of Mohammed. When a
new matter or question arises in Islam, Muslims consult these two
sources. If the sources provide a specific answer, Muslims must
abide by it, except in special or extreme situations. If the Qu'ran
and Hadeeth do not directly address the matter in question, local
boards of Islamic scholars provide guidance by consulting and interpreting
the two sources and issuing a decree, or fatwa.Scholars
sometimes disagree, depending on the question. In the case of Islamic
financing, scholars review and evaluate financial products based
on their consistency with principles contained in the Qu'ran and
the Hadeeth. They advise Muslims to avoid any financial products
that violate those principles. However, scholars may disagree about
the acceptability of products and services that are not specifically
prohibited under Islam.
For instance, the purchase of insurance products can be a source
of disagreement for Islamic scholars. Collective insurance is acceptable
under Islamic law, but selling insurance to make a profit is not.
There are exceptions; for example, many Muslims in the United States
purchase auto insurance because it is required by law. However,
it is not clear if mortgage insurance is acceptable. There are no
legal statutes that require mortgage insurance; it is a requirement
imposed by the financial industry, and different scholars have arrived
at opposing conclusions about its permissibility. There is also
considerable debate as to whether it is acceptable for a Muslim
to knowingly obtain a mortgage that will then be sold on the secondary
market, since that market conducts interest-based transactions.
Some scholars do not feel that the secondary market poses a problem,
as long as the transaction between the lender and the homebuyer
Scalability of models
Models such as the Hennepin County or NDC programs discussed above
work well for a small number of transactions at the local level.
However, these programs run into difficulty when the size or number
of loans demanded exceeds the capital available. One alternative
for regulated financial institutions that want to help meet the
credit needs of the Muslim community would be to help intermediaries
recapitalize and expand existing programs. In the Twin Cities market,
low- to moderate-income Somalis make up a large portion of the Muslim
community. Regulated financial institutions may be able to meet
their obligations under the Community Reinvestment Act by lending
to or investing in nonprofit organizations that provide Islamic
Outcomes in the Twin Cities
The issues explored above are central to the work group that formed
in 2001. Initially, the work group's goal was to bring Muslim community
representatives, lenders, and housing and small business assistance
providers together for the purpose of cross-education; that is,
to help lenders understand the Islamic principles underlying the
prohibition of interest, and to assist the Muslim community with
an improved understanding of American banking practices. The Minneapolis
Fed convened work group meetings and provided ongoing support by
facilitating discussion, researching specific issues and potential
alternatives and sharing information on models from other parts
of the country.
Early meetings focused on gauging the demand for Islamic financing
and exploring how it differs from traditional Western financing.
Over time, the work group's mission evolved into identifying barriers
to lender participation in Islamic finance, discussing how to eliminate
those barriers locally and researching replicable models from other
parts of the country. As a result of this process, several other
objectives were accomplished:
- The group developed a shared understanding of the primary issues
regulated financial institutions face in providing Islamic-financing
products. Key partnerships formed between bankers and community
organizations represented on the work group.
- Twin Cities lenders and Muslim community representatives gained
an improved understanding of the constraints that they each face
in providing or obtaining financing.
- The work group's efforts resulted in heightened awareness and
visibility of this issue in the larger Twin Cities community.
- Work group members and Muslim community representatives connected
with the local Homeownership Center to assist in the development
of an Islamic-focused homeownership-counseling program.
- And, most importantly, the knowledge exchange resulting from
this initiative is contributing to the development and introduction
of new products in the Twin Cities market.
Through their efforts, work group members discovered that developing
financing alternatives for Muslims and other interest-averse borrowers
is a complex and challenging process. This article explores key
issues involved, such as asset ownership, risk sharing and accounting
discrepancies, but the list presented here is certainly not exhaustive.
No single organization in the Twin Cities has the resources to
explore these issues alone. Together, lenders, community representatives
and other work group members have developed the expertise and momentum
necessary to advance alternative financing in the Twin Cities. They
demonstrated that partnerships are crucial for the development of
alternative-financing products, and they continue to work toward
Meanwhile, the demand for those products continues to grow, and
several key lending institutions are responding to the call. They
are studying existing models and working to develop products that
can effectively serve regional or national markets. Within the next
year, at least two additional Islamic-financing products should
be available in the Twin Cities. For area Muslims who wonder how
to buy homes or finance small businesses without violating their
religious beliefs, an answer may be coming soon.
Portions of our cover story are based on the article "Islamic
Finance and the U.S. Banking System" by Margaret Tyndall, which
appeared in the December 2001 issue of Community Investments,
a publication of the Federal Reserve Bank of San Francisco. To access
the issue, visit the "Publications" section of the San
Francisco Fed's Web site at www.frbsf.org.