Finance Methods - How IJARA Determines the Purchase Price

Finance Methods

IJARAH/IJARA

Ijara is defined as rent. The whole Sharia procedure is called Ijara-wa-Iqtina  which translates into renting to own. It’s important to understand this procedure is often used to purchase property and equipment. Once you get involved with Islamic finance, you’ll see how simple it is.

The foundation is a Trust which buys the home legally. As the name implies, any property bought through this system is then leased to the client. A piece of each pay out gets put towards ownership. The end result is the client owning 100% of the property.

An Islamic loan has one fundamental difference from the more traditional Western-style lease. There is an obligation for the Trust to sell what was purchased to the client by way of a Promise to Purchase. This type of contract gives the client the right to buy the property but doesn’t obligate them legally.

How IJARA Determines the Purchase Price

This is agreed to in the Promise to Purchase. The number equals the price the property was originally purchased for, subtract the client’s down payment minus $1.00. Here’s an example. For a property with an original purchase price of $200,000 and a $40,000 initial payment, the dollar amount the client needs to reimburse the investor to gain 100% ownership comes out to $160,001. An increasing number of payments reduces this amount until the last payment of $1.00 is attained.

Here’s How the Rent Is Determined

There are a series of rental payments financed through the client on a monthly basis. This starting point does earn money for the investor gets and is calculated using amortization formulas from traditional Western sources. It’s important to keep in mind there aren’t any contradictions with sharia law in these calculations.

However, there is one important difference in that a reverse amortization calculation is used in the Ijarah version. It might appear otherwise, but it is perfectly fine to outline a Sharia compliant finance transaction’s profit in terms of a percentage number.

Here’s an example.

  1. You start out with a cash sum of $100,000.
  2. You buy a home paying cash to purchase the property. 
  3.  The home is rented out at a monthly rate of $250.
  4. By year’s end, $3,000 has been collected in the form of rent.
  5. The $3,000 total incorporates 3% that comes back to you from the initial investment of 100,000 you invested.
  6. The 3% in question is considered rent on the property. This is considered Trade or Bey.

There’s also the question of whether this number is Riba or Rent.  The answer is Rent since the entire action is a business transaction. It’s helpful to look at how the same scenario works in a    mortgage transaction that’s more traditional:

  1. You start with the exact same amount of cash–$100,000 dollars.
  2. The money is given to another person.
  3. They purchase the property with the money given to them.
  4. They pay $250 monthly or 3% yearly for using the money.
  5. In this situation, this is Riba since there is rent being paid on the money.

In this scenario, the 3% is clearly Riba.  It’s different from the previous example that was rent on the individual property. If you’re looking at things from a Sharia perspective, the profits on any Islamic Ijara transaction can be described in a percentage form.

The Truth in Lending Act/Consumer Protection Act also comes into play here. This law requires that any of the profits that are made on residential property transactions need to be described in a percentage. This is about transparency so the customer can comprehend all of their financial requirements.

Being a Homeowner versus Tenant

Under the umbrella of Ijara Islamic financial transactions, each person is for all intensive purposes a tenant. There are several reasons for this including the fact that you will sign the legal document or lease that obligates a certain rent to be paid over a specific period of time.

There are some fundamental differences between this sharia compliant version and a more traditional property lease. In addition, you have the duties and rights of someone who would own the home in a more traditional sense.

Specifically, you are able to sell the house at any time as well as decorate or remodel. Under this sharia-compliant lease, you can also sublet and landscape. In other words, you can use the leased property for any and all of the purposes that it is legally zoned for.

There are some limitations. For example, you’re not allowed to do anything that can drive down the value of the property. Examples include demolishing a structure without putting a new one in its place.

The point is once you’ve met all the obligations that are clearly laid out with the lease and Promise to Purchase, you are basically a property owner.

How Your Share in Gains and Losses

Sharia compliance dictates that equal sharing of both gains and losses pertaining to any Islamic finance transactions must be observed. Ijara transactions are put together so that all of the gains goes to the customer.

Sharia dictates that gains or losses are distributed among the people involved in the transactions in accordance with their individual ownership percentages. Any Ijara transaction will abide by this guiding benchmark. In the time frame where loss or gain is being realized, the property has only a single owner that should always be the customer.

Here are some other guiding principles for procedures when the sale is being made:

 The Trust needs to transfer title and:

  1. The customer transfers the same to the buyer,
  2. The buyer settles the transaction in accordance with the agreement brought about with the customer,
  3. After that, the customer settles by contacting the Trust. This is once again in accordance with the agreement that has been signed between the Trust and the customer. This aspect includes the Ijara documents.

This procedure is designed so the customer holds 100% of the title, even though it’s just for a short amount of time. The customer is the beneficiary of any differences among the dual agreements. These include the sale as it pertains to the new buyer, as well as the Promise to the Purchase agreement that incorporates the Trust. Find out more by following these links  Ijara Contracts or Forward Dated Ijara Contracts. Please also see Other Islamic Finance Topics.