Islamic Finance - Ijara
The term Ijara literally means rent, the Sharia process is known as Ijara-wa-Iqtina, rent with an acquisition or rent to own. The process of Ijara can be used for equipment as well as property. This islamic finance process is very simple. A single asset Trust is created whereby the Trust purchases the property, and then leases the property to the customer. A portion of each monthly payment goes towards ownership, until the customer owns 100%.
The basic difference between a Sharia Ijarah-wal-iqtinah Islamic loan process and a conventional lease is the Ijarah process obligates the Trust (seller) to sell the property to you under a Promise to Purchase. While the same contract entitles the customer to purchase the property, the customer is not obligated to do so.
HOW THE PURCHASE PRICE OF THE IJARA TRANSACTION DETERMINED
The purchase price agreed to in the Promise to Purchase is equal to the original purchase price less the down payment made by the customer plus $1.00. For example, if the value of the property is $200,000 and the customer makes a $40,000 down payment, the initial amount the customer has to pay the investor for 100% ownership is $160,001. As the customer makes more payments, this amount reduces, until the final ownership payment of $1.00 is reached.
HOW THE MONTHLY IJARA RENT PAYMENTS CALCULATED
The initial Ijara islamic finance amount financed by the customer earns profit for the investor through monthly rental payments. Traditional amortization calculations are utilized to determine the exact monthly payment. The mathematical formulas are acceptable as there are no Sharia issues with these calculations. The major difference between a traditional mortgage amortization and an Ijara transaction is that the Ijarah transaction is based upon a reverse amortization calculation.
THE BASIS OF USING A PERCENTAGE
While it may appear contrary to the Sharia, it is acceptable to describe the profit on an Islamic finance transaction as a percentage. The following example highlights the acceptability of quoting the profit as a percentage in an Ijara transaction:
- Suppose you have a $100,000 in cash.
- You purchase a home and pay cash for the home.
- You rent the home to a tenant for $500 per month
- At the end of the year you have collected $500 x 12 or $6,000 in rent
- That $6,000 in rent is a 6% return on your $100,000 investment
Is that 6% Rent or Interest (Riba)? well it is clearly it is Rent since it is based upon a business transaction. Now let's look at a traditional mortgage interest transaction:
- Starting with the same $100,000 cash.
- You give someone the money.
- They proceed to purchase the same home with those funds.
- They pay you the same $500 per month, or 6% a year for use of the money.
- This is basically rent on money
In this case is the 6% Riba? Yes, as it is rent on money. The first example was rent on property. From a Sharia perspective it is acceptable to describe the profit on an Islamic Ijara transaction as a percentage. It’s also a requirement under the Truth in Lending Act/Consumer Protection Act; any profit earned on a residential real estate finance transaction should be described as a percentage so a customer can clearly understand what the overall cost of the financial transaction is.
TENANT OR HOMEOWNER?
In an Ijara islamic finance transaction, you are technically a tenant. You sign a lease obligating you to a rent payment over a period of time. However, unlike a typical rental property lease, you are responsible for all the maintenance of the property, and you have all the other rights and duties of a homeowner. You can sell the property anytime you wish, remodel, decorate, landscape, sublet, or basically utilize the property for any legal purpose it is zoned for. The only exception may be if you engage in an activity that may adversely affect the property’s value, like demolishing a garage without rebuilding it. For all practical purposes your role is the same as a homeowner, because once you have fulfilled your obligations under the lease or promise to purchase, you become the owner of the property.
SHARING OF A GAIN OR LOSS
One of the basic Sharia compliance principles is there should be a sharing of either a gain or loss in any islamic finance transaction. The Ijara transaction is structured in such a way 100% of the gain is rightfully the customers. Under the Shariah, the gain or loss is shared by the parties in a transaction according to their percentages of ownership. The Ijara transaction abides by this principle, in that at the time of realization of the gain or loss, there is only one owner of the property, and that is the customer. From a procedural perspective, at the time of sale:
- the Trust will transfer the title of the property to the customer,
- the customer will then transfer the title to the new buyer,
- the new buyer will then settle the transaction according to the agreement with the customer,
- and then the customer will settle with the trust according to the agreement between the customer and the trust (the Ijara documents)
These procedural steps create a situation where the customer holds 100% title, albeit for a short period of time, and is the beneficiary of the difference between the two agreements; that is the sale to the new buyer, and the original promise to purchase agreement with the trust. Find out more about Ijara Contracts or Forward Dated Ijara Contracts. There are links to Other Islamic Finance Topics
Ijara as a Financial Lease
Ijaraha with Diminising Musharakah