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An Islamic car finance is usually done using one of the following two products: murabaha or ijara wa iqtina. Before we understand its practical workings, it is important to define these principles.
Murabaha, translated from Arabic, means profit.
The underlying transaction is buying and selling of an asset.
For example, a customer approaches an Islamic bank for financing of a vehicle that costs, say, £30k. In a murabaha, the Islamic bank would buy this car for £30k, put its profit on top, say £10k for simplicity, and sell it to the customer for £40k. The ownership immediately passes to the customer. The customer would then pay the bank over a certain period of time – say 5 years. However, if the customer pays early, he/she would still have to pay £40k. The Islamic bank’s profit in a murabaha is fixed, and does not depend on when the customer pays – whether it is early or late.
Ijara wa Iqtina, translated from Arabic, means rent and acquisition. It is also known as Ijara muntahia bittamleek, which means rent ending in ownership.
In the case of Ijara wa iqtina, the underlying transaction is a rental agreement.
To continue the example above, if the customer wants a car that is worth £30k, the Islamic bank would buy the vehicle, it would retain the ownership of the vehicle, and rent it to the customer for a certain period of time – say 5 years. Afterwards, the ownership is transferred to the customer. If the customer pays rent over 5 years, the Islamic bank would earn £10k income. However, if the customer is able to pay for the vehicle sooner and finish the contract, say in 2 years, the Islamic bank would earn less. Thus, the Ijara wa Iqtina contract is more flexible, and allows the buyer to save, if he/she is able to pay for the vehicle sooner than originally planned.
In Surah Al Baqara, 275th Ayah, we recite “... they say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest.”
When compared just mathematically, trade and interest may look the same. You took out a loan for £30k, paid back £40k. On the other hand, you financed a car for £30k and paid back £40k. What is the difference?
There are many wisdoms in the Holy Qur’an the logic of which might not be immediately clear to us. As humanity, science and civilizations have progressed we have been able to understand the reason for many of the wisdoms. Why halal meat is good for us, why fasting is good for us and so on.
That is not to say we should not try to understand. So, for decades now, influential scholars across the Islamic world have looked at the Qur’an, the life of our prophet (peace be upon him), his financial transactions – as you know he was personally engaged in trading activities – and have agreed on a set of principles. Most of these principles are straightforward.
So let’s review some of the key differentiating factors between Islamic finance and traditional finance.
First of all, in Islam money itself does not inherently carry value. It is just a way for people to exchange goods and services that actually have value.
If someone gives you money and asks for more money back – there is no good or service being provided.
In the case of Islamic finance, the underlying contract is linked to a particular asset or service. The Islamic bank might be renting you an asset, selling you an asset, etc.
Mathematically you may or may not end up paying the same amount, but that is not what matters.
Part of the reason why Islamic banks have fared much better in the global financial crisis than traditional banks, is that Islamic banking is very much tied to the real economy. Every financing transaction is strictly tied to an asset or service provided. Most of the complex derivatives are forbidden in Islamic finance.
Secondly, financing any good or service that creates harm is forbidden. Thus, Islamic banks do not finance certain sectors, such as alcohol, gambling, tobacco, etc.
Thirdly, there is the element of penalties. An Islamic financing institution cannot make money from a situation where the customer is facing a difficulty. If the Islamic bank believes that the customer is delaying the payment without any valid reason, the Islamic bank has the right to request a certain amount to be paid to charity through the Islamic bank and it can’t be retained as bank’s income. The charitable cause has to be approved by the Shariah board of the bank. In our case, thankfully all our customers are paying on time, but if we ever had to do ask them to make a charitable donation, we allow the customers to propose a UK-based charitable fund to which the donation is to be made, and as long as our Shariah board approves, we would proceed that way.
Fourth, there is a certain process that needs to be followed. For example, in Ijara wa Iqtina, the order in which certain agreements are signed is critical.Initially, a “request for Ijara” is signed by the customer, where the customer requests the Islamic bank to acquire a certain vehicle, and the customer promises to rent this vehicle from the Islamic bank.
Next, the Islamic bank purchases the vehicle. Only after this step is complete, the Islamic bank can rent it to the customer, so an Ijara agreement is signed.
An Ijara agreement cannot by itself contain the sale element. The agreement for Sale and Purchase of the vehicle is signed only after the Ijara is concluded.
So typically an Ijara wa Iqtina consists of three separate steps, which cannot be put into one.
Not to oversimplify, but when we consider the difference between halal beef, and non-halal beef, often the difference comes down to the process: the steps undertaken in a certain order and manner.
Finally, the risk and reward differs in Islamic finance.
With murabaha for example, the Islamic bank retains the risk of ownership of the vehicle for the short period of time that it owns it. In the Ijara wa Iqtina, the Islamic bank would retain the risks related to ownership, while the customer bears responsibility related to the usage of the vehicle.
For instance, if something happens to the vehicle at the dealership before the customer has picked up the vehicle, and for some reason it was not insured, the customer has no responsibility to the bank.
Or to give another example, when the customer is using the vehicle, and something happens to the vehicle which is not due to negligence and misuse of the customer, and there is a total loss, the insurance would provide a pay-out to the Islamic bank – however, even if that payout does not cover the amount owed by the customer to the Islamic bank, the customer would have no further liability to the bank.
There is a common misconception that if Islamic finance has to be charitable. For sure, an Islamic bank can be charitable, if it wants to. Just like any entity could be. In fact there is also a product that some Islamic banks have, which is called Qard Hasana. This is indeed a loan given by an Islamic bank to a customer, and the Islamic bank does not earn anything from this.
However, just like any business can make halal income if they operate in a halal manner, an Islamic bank can make halal income as long as it operates within Islamic finance principles. The more Islamic banks there are, the more competition there would be in the sector, and the more customers would benefit from this.