Islamic finance practices have additional restrictions not found in secular banking. Islamic law, or sharia, prohibits the payment or acceptance of riba, commonly known as usury. Beginning in the late 20th century, Islamic financial institutions were formed to comply with sharia while still allowing the financial institution to make a profit. This essentially requires the Islamic financial institution to lease an asset instead of loaning money on it.
Usufruct is the right of one party to use property that belongs to another party, including property that is commonly owned by both parties. It also includes the right to benefit from that property, which typically means you can derive profit from it. Some countries such as Mexico use a system in which land cannot be owned and only the property’s usufruct can be purchased.
A lease is the sale of an asset’s usufruct from a lessor to a lessee. The lessor retains ownership of the property, including all of the rights and responsibilities of ownership. Common types of property that are leased in the United States include automobiles and real estate, especially apartments. Islamic finance law does not allow Islamic financial institutions to loan money in exchange for interest. However, it does allow the bank to lease an asset for a specific period of time in exchange for some consideration such as money. Ijarah is the Arabic word for “rent”, and it also refers specifically to a type of lease that conforms to Islamic finance law.
An ijarah generally involves the Islamic financial institution purchasing an asset as specified by the customer. The financial institution and the customer agree on the terms of the contract, including the period of the lease and the rental fee of the lease. The Islamic financial institution retains ownership of the asset while the customer acquires the right to use the asset. In this type of Islamic finance transaction, the customer is paying a rental fee for the use of a financial asset rather than interest on a loan.
Ijarah Muntahia-bi-tamleek is a specific type of ijarah under Islamic finance law. This type of lease concludes with the transfer of the property’s ownership from the lessor to the lessee. The lease of the property and its subsequent sale must be separate transactions in order for an Ijarah Muntahia-bi-tamleek to be acceptable under Islamic finance laws. An ijarah muntahia-bi-tamleek is more commonly known as ijarah wa iqtina. This term makes it more clear that the lease and sale are separate transactions.