Sharia mortgages and millennial homeowners

The share of first-time buyers is at its lowest in 30 years. Could innovations from Islamic finance - such as "lease to own" and "co-ownership" - help aspiring homeowners overcome cash and credit hurdles?

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The homeownership rate for Americans under age 35 is at its lowest in decades. To help expand millennial homeownership, innovations from Islamic finance could help.
Federal mortgage giants Fannie Mae and Freddie Mac recently announced a plan to loosen the too-tight credit standards that have made it so tough for many millennials to reach that quintessential milestone of adulthood: owning a home. While details are still forthcoming, a key component of the plan is to lower the minimum down payment requirement for some credit-worthy borrowers to 3 percent.

It still may not be enough, however, to solve the cash and credit problems facing aspiring millennial homeowners. When the real estate firm Redfin looked at the 20 hottest zip codes in the country for college-educated millennials, it found the average down payment in these neighborhoods was $80,000.

And many millennials may not have the credit to qualify even under the soon-to-be relaxed standards. As Chief Economist Jonathan Smoke told me, “The average millennial credit score is below 620, which is the floor for all of the mortgages that have been written in the past few years.”

But instead of just expanding the so-called “credit box” for potential homebuyers, perhaps it’s time to think outside the box altogether.

In particular, one option might be to look to the world of Islamic finance.

Though developed for a niche market, so-called “Sharia mortgages” – including such creative innovations as “lease to own” and “co-ownership” –  have features that could benefit struggling millennials, including low down payment requirements. But while relaxing lending standards makes both lenders and regulators nervous because of the increased risk of default, Islamic finance models don’t have the same problem.

In fact, the beauty of these arrangements is that they solve the cash and credit hurdles facing aspiring homebuyers – and lenders – by turning the conventional mortgage model upside down. Here’s how.

Under a conventional agreement, the lender’s primary financial interest is in the mortgage loan itself and seeing that it gets repaid. That’s why borrowers need good credit and “skin in the game” with a big down payment so they’re less likely to default.

The lender’s interest is in the house in secondary – and really only for its value as collateral. If a borrower does fault, the lender can recoup the balance by taking title to the house (i.e., via foreclosure) and selling it.

Islamic law, however, forbids the payment of interest – thereby making conventional mortgage loans impermissible. To comply with these restrictions, Islamic finance companies have devised a variety of ingenious alternatives, including “lease to own” agreements and “co-ownership” arrangements, in which home equity gradually transfers from the finance company to the homeowner with each payment.

What these arrangements have in common is that the primary financial interest of the Islamic financial companies is in the house. By owning or co-owning a home to begin with, companies that take this approach can eliminate the need for a big down payment and worry less about a borrower’s credit.

For example, the leading Islamic finance company Guidance Residential, based in Reston, Virginia, offers a so-called “declining balance co-ownership program,” which requires a five percent down payment from aspiring homeowners. Guidance puts up the rest in exchange for 95 percent co-ownership of the home.

Over time, the homebuyer buys out Guidance’s ownership share through monthly payments (what would otherwise be the equivalent of mortgage payments in a conventional scenario). And instead of interest, homeowners pay a monthly “profit payment” intended to compensate Guidance for the exclusive right to live in the house. (The amount of the profit payment, incidentally, is “competitive with prevailing interest rates,” according to Guidance.)

Another option, offered by InjaraUSA, is “lease to own.” Under this arrangement, homeowners are technically tenants who pay rent on the home they want to own for a specified period of time. At the end of the term, the title transfers to the owner. To participate in these transactions, Injara requires a minimum down payment of 3.5 percent.

Innovations like these could prove an effective model for a new wave of financial innovation aimed at young buyers. Experimenting with these models would also require no intervention from a Congress too gridlocked to do anything anyway.

More importantly, it would cost no taxpayer money.

In the immediate aftermath of the financial crisis, Congress passed a temporary $7,500 first-time homebuyer tax credit in 2008, which the National Association of Realtors credited with pushing the share of first-time homebuyers to 51.5 percent of the market six months after its enactment.

But as popular as the credit was, it was also expensive – costing an estimated $9.9 billion from 2008-2012, according to the Congressional Joint Committee on Taxation. Given the current political climate, a reboot of the credit is unlikely.

Would millennials go for the kinds of arrangements pioneered by Islamic finance, and if they would, why don’t these models exist in the mainstream market already?

It turns out the mainstream mortgage market is already inching toward these kinds of innovations.

For example, so-called “shared equity” mortgages have been part of the landscape for years. Under one variety of these arrangements, a third party – such as a parent – puts up part of the down payment in exchange for a return on this investment plus a share of the profits when the home is sold.

A number of economists and others championed another variation of these mortgages shortly after the financial crisis, when millions of homeowners found themselves “underwater” – owing more on their mortgages than their homes were worth. Here, the idea was for banks to agree to write down borrowers’ mortgages in exchange for a share of the future appreciation in the home.

The difference with these types of mortgages is that the “equity sharing” doesn’t happen until the home is sold (assuming the property does, in fact, appreciate). Under Islamic finance co-ownership arrangements, the equity sharing happens upfront.

That being said, the fact that shared equity mortgages have existed for years means that having lenders participate in the equity of a home is not an alien concept for mainstream mortgage finance.

And if you need another indicator of mainstream acceptability, government mortgage giant Freddie Mac buys Sharia mortgages and has done so since 2001. (Guidance Residential includes in its FAQs an explanation of why the sales of its contracts to Freddie Mac are Sharia-compliant.)

The biggest obstacle for millennials and other aspiring first-time buyers interested in these kinds of arrangements is that Islamic financial institutions don’t make their products available to non-Muslims. The Islamic finance market is itself also still tiny. Guidance Residential, which is among the largest and best-known companies, has financed $2.9 billion in transactions and operates in 22 states.

Nothing, however, is stopping Bank of America from trying it out, at least on an experimental scale. And there’s every indication that the demand for homeownership is there.

Though some may argue that footloose millennials, unlike their staid elders, are more likely to eschew homeownership, a September 2014 survey by Zillow found that 65 percent of young adults ages 18 to 34 think owning a home is “necessary to live The Good Life”; the same percentage believe that a home is “the best long term investment”; and 74 percent think “owning a home provides a person more freedom.”

Nevertheless, according to Census data, the homeownership rate among Americans under age 35 was just 35.9 percent at the end of June 2014 – the lowest it’s been since at least 1994.

Moreover, first-time buyers – the majority of whom are young – are conspicuously absent from the housing market. In August 2014, 29 percent of home purchases were by first-time buyers, well below the historical norm of 40 percent. According to the latest annual survey from the National Association of Realtors, the share of first-time buyers in the market is in fact at its lowest in three decades.

Certainly, lending standards have become far more restrictive than they need to be. But looser standards alone won’t be enough to help first-time and millennial buyers enter a housing market that’s been determined to shut them out. The right kinds of financial innovation, however, could provide the extra boost these homebuyers need.

Anne Kim is Editor of Republic 3.0. Follow: Anne_S_Kim