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What is Islamic Finance?
Table of Contents
- What is Islamic Finance?
- ISLAMIC FINANCIAL TERMS:
Islamic Finance has been gaining prominence around the world specifically in Malaysia and GCC countries in the recent years. Although Islamic Finance in as old as Islam itself, it has gained popularity in the recent decades. Islamic serves the same purpose as that of conventional banking but the methodology or the working of the product differs.
To put it in simple words, Islamic Finance or Banking is banking activity which is consistent with the Islamic Law or Sharia as it is called. Islamic Finance or Sharia prohibits acceptance of interest payments – Riba (interest) on loans, which means banks and financial institutions that follow sharia principles are not supposed to charge any interest on the money they lend. It also prohibits in investing in business activities that are against the Islamic Principles such as liquor, business of pork, gambling and so on.
How do Islamic Banking institutes make money then?
As mentioned, Islamic banking and financial institutions are forbidden from charging interest to consumers. How do they make money? Islamic banks charge what is known as profit(loss) to their consumers. You must understand here that profit is not a mere replacement of the term interest. But it has other connotations. Islamic Banking is always a 2 way transaction in the sense of profit and loss. For example, under conventional banking, the bank is supposed to pay interest towards the deposits whether the bank makes profit or loss. Under Islamic Finance, for any deposits made, bank is not obliged to pay profit if the bank incurs losses. The consumer has also to partake in the losses if the bank itself has undergone loss.
Although Islamic Finance is used in many banking products, mortgage is a main product.
Here I have explained the working of Ijara Mortgages:
When it comes to Islamic finance and Islamic mortgages, the primary goal is to make sure that nobody profits unreasonably from any sale or leasing agreement. Both the buyer and seller or the lender and borrower should benefit from any transaction, as dictated by Shariah or Islamic law. The Islamic law system is designed to be completely just and fair so that no one is taken advantage of, and so there are many specific provisions to consider when engaging in this type of transaction.
One of the biggest considerations that you are going to want to make when it comes to a Islamic mortgage is that Islamic mortgages cannot charge interest payments from the borrower. The reason is because interest payments allow the lender or bank to profit unreasonably from the sale of the home. Islamic financing, then, should always be interest free financing or free of Riba. The bank or lender is still going to earn a commission or a profit on the sale of the home, because every business should earn a profit, but by avoiding charging interest, the lender or bank is going to earn a fair profit and the home buyer or borrower is not going to pay a fair price in the process.
Islamic finance follows Shariah, the rules of Islamic law, and so this area of financing is quite unlike traditional western world financing. If you are a home buyer, or a lender trying to work with home buyers, then you need to become well versed in this type of financing so that you can make sure your transactions are conducted in accordance with Islamic law. It will take a little bit of research and understanding to grasp how this type of financing works, but the effort is well worthwhile when you consider the benefits.
Regular mortgages and Islamic mortgages are quite different for several reasons. Make sure that you understand what these differences are, because you have to follow Islamic law and avoid Riba while conducting this type of financial transaction.A little bit of research will help your understanding of the Islamic Finance process and can really go a long way in making sure that you conduct these types of transactions safely and in a manner that benefits all involved parties equally.
IJARA – Lease To Own
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 Ijara-wa-iqtinah Islamic loan process and a conventional lease is the Ijara 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 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 Ijara transaction is based upon a reverse amortization calculation.
Why is percentage used in Islamic Finance?
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 an AED 100,000 in cash.
- You purchase a home and pay cash for the home.
- You rent the home to a tenant for AED 500 per month
- At the end of the year you have collected AED 500 x 12 or AED 6,000 in rent
- That AED 6,000 in rent is a 6% return on your AED100,000 investment
Is that 6% Rent or 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 AED 100,000 cash.
- You give someone the money.
- They proceed to purchase the same home with those funds.
- They pay you the same AED 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.
Is the borrower tenant or homeowner?
In an Ijara islamic finance transaction, borrower is 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. You might need developer’s permission to do that in most cases. 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.
Basis of Islamic Finance: 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 is the customer’s. 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.
ISLAMIC FINANCIAL TERMS:
AR-RAHNU (Collateralized Borrowing):
Refers to an arrangement whereby a valuable asset is placed as collateral for debt. The collateral may be disposed of in the event of default.
Earnest money/down payment; a non-refundable deposit paid by the client (buyer) to the seller upon concluding a contract of sale with the provision that the contract will be completed during the prescribed period.
Trust, trustworthiness, faithfulness and honesty. Most widely understood and used to identify a transaction where one party keeps another’s funds or property in trust. Also used to describe different financial or commercial activities such as deposit taking, custody or goods on consignment.
AS-SARF (Foreign Exchange):
Refers to the buying and selling of foreign currencies.
BAI’AL-DAYAN (Debt Trading):
Refers to debt financing i.e. the provision of financial resources required for production, commerce and service by way of sale/purchase of trade documents and papers. Only documents evidencing real debts arising from bona fide merchant transactions can be traded.
BAI’AL-INAH (Sale and Buy Back Agreement):
The financier sells an asset to the customer on a deferred-payment basis, and then the asset is immediately repurchased by the financier for cash at a discount. The buying back agreement allows the bank to assume ownership over the asset in order to protect against default without explicity charging interest in the event of late payments or insolvency.
BA’AL-ISTIJRAR (Supply Contact):
Refers to an agreement between the client and the supplier agrees to supply a particular product on an ongoing basis, for example monthly, at an agreed price and the basis of an agreed mode of payment.
BAI’ AS-SALAM (Future Delivery):
Refers to an agreement whereby payment is made immediately, while the goods are delivered at an agreed later date. It is equivalent to an advance payment.
BAI’BITHAMAN AJIL (Deferred payment sale):
Refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties.
BAI MUAJJAL (Credit sale):
Literally, bai muajjal means a credit sale. Technically, it is a financing technique adopted by islamic banks that takes the form of murabah muajjal. It is a contract in which the bank earns profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the price or higher or lower than the spot price.
A necessity or emergency. This is a condition in which aspects of the sharia may be suspended in order to preserve life, or assure the safety of the Islamic community, or a individual.
An Islamic legal opinion based upon Qur’an, Sunnah and Islamic legal precedent- collectively the Shari’ah.
Plural of faqih. Jurist trained in islamic law or the Shari’ah in particular, according to the four leading teachers: Maalik, Abu Hanifa, Shafi’e and ibn Hanbal.
Uncertainty. One of three fundamental prohibitions in Islamic finance (the other two being riba and maysir). Gharar is “a sophisticated concept that covers certain types of uncertainty or contingency in a contract”. This is often used to highlight the perceived shortcomings of conventional financial practices such as short selling speculation and derivatives. Simply, selling something you may not be in a position to deliver.
Acceptable under Shari’ah.
Forbidden under Shari’ah.
Refers to gifts awarded voluntarily in return for loan given
Refers to a transfer of funds/debt from the depositor’s/ debtor’s account to the receiver’s/ creditor’s account, whereby a commission may be charged for such service.
Refers to an arrangement under which the lessor leases equipment, a building or other facility to a client at an agreed rental against a fixed charge, as agreed by both parties. Ijara wa iqtinah extends the lIjara concept to a hire and purchase agreement.
Pre-delivery financing and leasing instrument used to finance long-term projects.
Refers to guarantee provided by a person to the owner of goods, who had placed or deposited his goods with third party, whereby the guarantor and the third party must meet any subsequent claim by the owner for his goods.
Gambling. Another of three fundamental prohibitions in Islamic Finance (the other two being riba and gharar). Maysir is often used to highlight the perceived shortcomings of conventional financial practices such as conventional financial practices such as speculation, conventional insurance and derivatives.
Mudarib is the entrepreneur or investment manager (in a mudarabah) who invests the investor’s funds in a project or portfolio in exchange for a share of the profits.
Refers to an agreement made between a party, who provides the capital, and other party (entrepreneur), to enable the entrepreneur to carry out business projects, which will be on a profit sharing basis according to predetermined ratios agreed upon earlier. In the case of losses, these are borne by the provider of the funds.
MURABAH (Cost Plus Financing):
Murabaha is the Contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank, which then sells them to the client at an agreed markup. Repayment is usually in installments.
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between the seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from Murabah in respect of pricing formula. Unlike Murabaha, however, the seller in Musawamaha is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to Murabaha are valid for Musawamah as well. Musawamaha can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.
MUSYARAKAH (Joint Venture):
Refers to a partnership or joint venture for a specific business with a profit motive, whereby the distribution of profits will be apportioned to an agreed ratio. In the event of losses, both parties will share the loss on the basis of their equity participation.
QARADHUL HASSAN (Benevolent Loan):
This refers to an interest free loan. The borrower is only required to repay the principal amount borrowed, but he may pay an extra amount at his absolute discretion, as a token of appreciation.
This term literally means an increase or addition. Technically, it denotes any increase or advantage obtained by the lender as a condition of the loan. Any risk-free or “guaranteed” rate of return on a loan or investment is Riba, in all forms, is prohibited in Islam. In conventional terms, riba and “interest” are used interchangeably.
Salam is a purchase contract with deferred delivery of goods, suitable for agriculture finance.
Islamic law derived from three sources- the Qur’an, the Hadith and Sunnah.
An independent professional, usually a classically trained Islamic legal scholar, who advises an Islamic bank on the compliance of its products and services with the Shari’ah or Islamic law. Some Islamic banks consult individual Shari’ah advisor and some establish a committee of Shari’ah advisors (the Shari’ah board or Shari’ah committee).
A term used in the Islamic banking industry as a synonym for “Islamic” essentially an act or activity complying with Shari’ah, or Islamic law.
Similar charecteristics to that of a conventional bond with the difference being that they are asset backed; a sukuk represents proportionate beneficial ownership in the underlying asset. The asset will be leased to the client to yield the return on the sukuk.
Arabic for solidarity. This is a form of Islamic insurance based on the Quranic principle of Ta’awon, or mutual assistance. It provides mutual protection of assets and property and offers joint risk sharing in the event of a loss by one of its members. Takaful is similar to mutual insurance in that members are the insurers as well as the insured. Conventional insurance is prohibited in Islam because its dealings contain several haram elements including gharar and riba, as mentioned above.
Reverse murabaha. In personal financing, a customer with a genuine need buys something on credit from a bank on a deferred payment basis and then immediately resells it for cash to a third party. Therefore, obtaining cash without taking a loan based on repayments plus interest.
Refers to commissions or fees charged for services.
WADIAH YAD DHAMANAH (Savings with Guarantee):
Refers to goods or deposits that have been deposited with another person, who is not the owner, for safekeeping. As wadiah is a trust, the depository becomes the guarantor and, therefore guarantees repayment of the whole amount of the deposits, or any part thereof, outstanding in the account of depositors when demanded, but the depository may provide returns to the depositors as a token of appreciation.
WAKALAH (Nominating another person to act):
Refers to a situation where a person nominates another person to act on his behalf. Absolute power of attorney.
Literally, “purifying dues”. A tax which is prescribed by Islam to be paid to specific people by all Muslims having wealth above their basic needs. The exemption limit is set by the Shari’ah.