How Will Banks Calculate Interest on a Loan of 210,000 Dinars with a 25-Year Term?

- Legally, a customer is not permitted to own the financed residential property from the moment the loan is disbursed until all installments are fully paid.

- The Central Bank is discussing with banks the establishment of a clear mechanism within the sector.

- The tenor of real estate financing has increased by approximately 1.6 times, while its commercial value has doubled.

- Religious rulings permit financing at a single rate for the full term, and another model based on installment-based financing.

- Interest rates on traditional bank real estate financing are subject to change, with adjustments allowed up to four times.

As policymakers in banks, particularly those overseeing personal loans, await the issuance of the executive regulations for the Real Estate Financing Law and the specific guidelines set by the Central Bank of Kuwait, banking expectations are growing that all banks will compete fiercely to increase their market share in this segment. This competition will likely be driven through interest rate windows, innovative financing solutions, and strategic partnerships with suppliers and construction sector players.

This question is not hypothetical; it has strongly emerged on the agendas of bank executives for discussion and the formulation of possible pricing concepts within the contractual frameworks used in real estate financing, in an effort to reorganize the necessary regulatory matters with Islamic banks that operate in accordance with Sharia law, particularly regarding the contracts for the financing they will provide in this sector, which is poised for a financing boom.

The answer to this question may be more readily available to executives of traditional banks, and technically and accounting-wise simpler, based on the fact that traditional banks operate on a credit basis using flexible interest rates for each cycle. In accordance with the policy of the Central Bank of Kuwait, these banks review the interest rate applied to their loan portfolios every five years.

If the interest rate increases by the end of the loan term granted to the customer, the interest rate for the remaining installment period is automatically adjusted upward by a percentage parallel to the prescribed increase. The same applies in the case of a decrease, meaning that the interest rates of traditional banks are subject to change, either upward or downward, up to four times if the customer obtains real estate financing for 25 years.

With the contractual changes that will occur upon the approval of the Real Estate Financing Law, particularly regarding the tenor, which will increase in duration by approximately 1.6 times, as the repayment period for residential financing will extend to 25 years instead of 15 years, and the maximum value limits will double from 70,000 dinars to 140,000 dinars. In addition, subsidized financing allows eligible beneficiaries to combine subsidized and non-subsidized financing, adding another 70,000 dinars to the maximum limit.

As all banks expand their participation in residential financing, the question arises again: What will banks operating in accordance with Sharia law do within the framework of a new financing model that offers promising opportunities for up to 25 years?

To simplify, according to the business model of banks operating in accordance with Islamic Sharia, they cannot unilaterally initiate adjustments to the financing interest rate for the customer, either upward or downward, every five years as traditional banks do. Conversely, the customer has the right to request such adjustments when they become due, as is the case with traditional banks. This means that the process for determining interest rates on financing extending over 25 years is not fully mapped out procedurally in the sector of Islamic banks.

The need for Islamic banks to establish a roadmap for the interest rates on their anticipated real estate financing is further heightened by their reliance on Sharia-compliant financing types in their transactions, such as deferred sales, including Murabaha to the Purchase Orderer. To calculate the profit margin or rate of return in a Murabaha to the Purchase Orderer transaction, two fundamental factors must be considered: the cost of purchasing the asset for the bank, and the profit margin charged.

It is well known that this ratio is not fixed. If the Islamic Bank sells the property under a Murabaha arrangement with the price payable in installments over 15 years—the current maximum tenor for housing finance—the ratio will be lower than if it were sold on installment terms over 25 years, which is the anticipated new tenor for real estate financing. More importantly, Ijarah contracts require the financing bank to own the residential property from the moment the financing is disbursed until the final installment is paid. This practice is no longer permitted under the new real estate financing law.

As the new real estate financing framework imposes a new credit reality on banks operating in accordance with Shariah, characterized by different values and tenors, contemporary fatwas are needed to keep pace with anticipated contractual changes. Fatwa officers in these banks are exploring the development of an alternative contractual structure to help their business units mitigate the risks associated with continuing to apply a fixed-rate model over the new financing tenor.