How It Works
The Islamic Basis Of This Product
Amanah Islamic Finance Australia Pty Ltd.’s (Amanah) home financing product uses the Islamic principle of Ijarah. The concept of Ijarah is a well-established principle in Islamic jurisprudence which has been adapted by Islamic financial institutions, in a modern context, as a permissible mode of Shariah compliant finance. By way of example, it has been used to facilitate home finance by Islamic banks in the Middle East, Malaysia, Pakistan and South Africa.
The authoritative reference material that supports the analysis in this product information report is based on the following texts where the topic of Ijarah is analysed in significant detail:
- The Ijarah standards of the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) where Mufti Dr Imran Usmani is a member of the Executive Committee
- Meezan’s Guide to Islamic Banking by Mufti Dr Imran Usmani
- An Introduction to Islamic Finance by Justice (ret) Sheikh Mufti Muhammed Taqi Usmani
After significant deliberation it was decided by Amanah’s Shariah adviser, Mufti Dr Imran Usmani, in consultation with Justice (ret) Sheikh Mufti Taqi Usmani, that for home financing in Australia, Ijarah is the preferred method over other permissible Islamic contracts.
The primary reason for this is that the economic outcome of Ijarah is more closely aligned to the reality of the underlying Australian commercial and regulatory context for such a financing. It was concluded that other contracts such as the diminishing partnership based Musharaka Mutanaqisa (while permissible in itself) had economic outcomes which differed greatly from the actual substance of the home financing arrangement when implemented. In this regard, over a period of six months intensive product development was undertaken by Amanah in developing a product using the concept of Shirkatul Milk (another Musharaka model). The product when scrutinised produced economic consequences at odds with its intended Shariah outcome.
It is the view of Mufti Imran Usmani and Mufti Taqi Usmani that the minimum required amendments for a valid diminishing Musharaka product would not be possible given the Australian regulatory and commercial environment.
For that reason Ijarah was preferred over diminishing Musharaka.
This home financing product is based on the Islamic principle of Ijarah.
The concept of Ijarah is a well-established principle in Islamic jurisprudence.
The principal documentation that underpins the home financing arrangement manifests this intention of the parties by outlining the constituent elements which create a valid Ijarah for the purposes of Shariah.
Justice (ret.) Mufti Muhammed Taqi Usmani provides a useful background to the use of Ijarah as a permissible mode of Islamic financing. In his text at page 109, he notes the following:
- “Ijarah” is a term of Islamic fiqh. Lexically, it means ‘to give something on rent’. In the Islamic jurisprudence, the term ‘Ijarah’ is used for two different situations
- In the first place, it means ‘to employ the services of a person on wages given to him as consideration for his hired services
- The second type of Ijarah relates to the usufructs [e.g. The right of use and enjoyment] of assets and properties, and not to the services of human beings. ‘Ijarah’ in this sense means ‘to transfer the usufruct of a particular property to another person in exchange for a rent claimed from him.’ In this case, the term ‘Ijarah’ is analogous to the English term ‘leasing’. Here the lessor is called ‘mu’jir’, the lessee is called ‘musta’jir’ and the rent payable to the lessor is called ‘ujrah’
- Both these kinds of ‘Ijarah’ are thoroughly discussed in the literature of Islamic jurisprudence and each one of them has its own set of rules…the second type of Ijarah is more relevant, because it is generally used as a form of investment, and as a mode of financing also [emphasis added]
- The rules of Ijarah, in the sense of leasing, is very much analogous to the rules of sale, because in both cases something is transferred to another person for a valuable consideration. The only difference between Ijarah and sale is that in the latter case the corpus of the property is transferred to the purchaser, while in the case of Ijarah, the corpus of the property remains in the ownership of the transferor, but only its usufruct i.e. the right to use it, is transferred to the lessee
- The question whether or not the transaction of leasing can be used as a mode of financing in Shariah depends on the terms and conditions of the contract. As mentioned earlier, leasing is a normal business transaction and not a mode of financing. Therefore, the lease transaction is always governed by the rules of Shariah prescribed for Ijarah
The Transaction Flow and Principal Shariah Documents
Essential Elements of Ijarah Under the Shariah
We now discuss the basic rules governing Ijarah as enumerated in the Islamic Fiqh and how they apply to this product.
Under the Amanah’s Ijarah Financing contract the first payment is due one month after settlement date which is the date that the Financier advanced money which was applied to the purchase of the property. Practically, this means that the first payment is due one month after the Customer obtains use of the property. This is in accordance with Shariah.
From a Shariah perspective, in the first instance, the client is a Wakeel (the Shariah equivalent of an agent) of the institution to purchase the asset on the latter’s behalf. At this stage, the relation between the parties is nothing more than the relation of a Wakeel and his Muwakel.
In Amanah’s product, the Financier appoints the Customer as its Wakeel under a Wakala agreement and the Customer, initially, acquires the Property on behalf of the Financier as purchasing and custody agent, (and mortgages it to the Financier) who will thereby acquire a beneficial interest in the Financed Property.
This is acceptable in Shariah.
The second stage begins from the date when the client takes delivery from the supplier. At this stage, the relation of Mustajir and Ajir comes to play its role.
The Amanah Ijarah Financing Agreement documents the intention of the parties that the Financier provides the financing to enable the Customer to obtain the use of the Property in a manner that is consistent with the principles of the Shariah under the concept of Ijarah for which the Customer will make rental payments which comprise the amount that was applied to the purchase of the Financed Property and our profit which is the amount calculated using the rental rate.
According to Shariah, the Financier is regarded as the owner of the asset, and he has purchased it, through his Wakeel, from the vendor. Accordingly, the Shariah would the financier liable to pay all the expenses incurred in the process of its purchase. However, he can, of course, include all these expenses in his cost and can take them into consideration while fixing the rentals.
In the Amanah Wakalah agreement, the Financier represents, and the Customer acknowledges, that the rental payments are set at a level which allows the Customer to also pay all amounts in respect of the property. In addition, under its obligations associated with the mortgage the Customer agrees to keep any mortgaged property in good repair and to pay all rates, taxes, and other expenses in relation to the property.
This is in accordance with Shariah.
It is the practice in Australia for Financiers to require that the financed property be insured. These requirements exist across the world including, in Islamic banks such as at Meezan Bank in Pakistan where Takaful (an Islamically permissible form of insurance) is used.
Takaful is not available in Australia. We overcome this problem by including a term in the Wakalah Agreement which states that the Customer is purchasing the insurance on behalf of the Financier, and the Financier has adjusted the payments to include the insurance premium. This acknowledgement in relation to premium payment is expressly recognised and evidenced as a key term of the Wakalah.
From a Shariah perspective, the Amanah contracts have been drafted such that the Financier is considered as the one purchasing, and enjoying the benefit of the insurance. In these circumstances, the insurance is permissible under Shariah.
The typical home financing agreement has a term of 30 years and, as market conditions change over time, it would not be practical for the Financier to fix the component of rental that relates to its profits e.g. The amount calculated using the rental rate.
Many credit contracts in Australia contain the following provision:
If the Lender varies the rate you will be notified in accordance with applicable laws on or before the day the change takes effect either in writing or by advertisement in a major newspaper or by electronic means.
This clause effectively allows the rate to fluctuate on a daily basis, which is not permissible from a Shariah perspective.
The above clause which is a feature of most Australian home loans is expressly excluded under Amanah’s contract.
It may be permissible from a Shariah perspective for the rental rate to vary, however there are strict conditions which must be followed.
- How should Islamic institutions vary rental rates by benchmarking?
It may be possible to use a pre-determined formula which tracks the rental rate against an industry wide benchmark such as the Reserve Bank of Australia’s cash rate (RBA Cash Rate). However, from a Shariah perspective, any fluctuation must only take into account movements in the RBA Cash Rate (and nothing else).
This problem is that many Australian banks and financial institutions will also take into account a range of factors such as the wholesale cost of funding, shareholder returns and other expenses.
By way of example, in a recent meeting of the Reserve Bank it was decided that the RBA Cash Rate be reduced by 0.25% to stimulate the economy. However, some lenders only reduced their financing rate by a small portion of this 0.25% because they had to consider other factors such as rising costs and the needs of their depositors.
This approach to benchmarking is not permissible from a Shariah perspective.
Amanah does not use floating rates in the way other Australian financial institutions utilise them (which is generally contrary to accepted Shariah principles). Instead, Amanah uses fixed approach noted below.
- Varying the rate by agreeing to a shorter fixed term rate
The Financier and Customer can agree to fix the rate under the contract for a specified term and then upon expiration of that term renegotiate the rate for a further term. The term must be real and not nominal e.g. It cannot be a matter of days.
From a Shariah perspective, at the expiration of the term, if the Customer does not accept the new rate proposed by the Financier then the Customer must be at full liberty to terminate the contract without penalty.
In the Amanah Ijarah Financing Agreement the rental rate is not a floating rate. The Rental Rate percentage is fixed for a period. At the end of the period the customer and financier then renegotiate a further 12 month fixed rate period. If the Customer is not happy with the new rate he may terminate the agreement without any break costs.
There are strict Shariah requirements on the permissibility of applying penalties for late payments. The Shariah position as outlined by Sheikh Mufti Taqi Usmani in his book can be summarised as follows:
In some agreements, a penalty is imposed on the lessee in case if he delays the payment of rent after the due date. This penalty, if meant to add to the income of the lessor, is not warranted by the Shariah [emphasis added]. The reason is that the rent after it becomes due, is a debt payable by the lessee and is subject to all the rules prescribed for a debt. A monetary charge from a debtor for his late payment is exactly the riba prohibited by the Holy Qur’an. Therefore, the lessor cannot charge an additional amount in case the lessee delays payment of the rent [emphasis added].
It is the practice of many conventional banks and financial institutions to include in their penalty rates the opportunity cost of the Customer’s default e.g. The Lender would have used that interest income (which the Customer has not paid) to on-lend to another customer and this default fee is effectively getting the Customer to compensate it for those lost profits.
Any default payment that takes this into account is not permissible.
Under the Amanah Ijarah contract, the Financier makes an express contractual representation to the Customer that the default rate of rental and default fees have been set at a level to include the actual costs of administering the Customer’s default. This includes enforcement expenses and internal resources (e.g. staff costs) required in connection with managing the default by the Customer. This approach is permissible from a Shariah perspective.
The Ijarah Financing Agreement is accompanied by a Wa’ad or “sale undertaking”. The combination of Ijarah and Wa’ad makes a simple Ijarah into a financing arrangement and this approach is widely accepted in Shariah and practised by many Islamic banks.
Under the Wa’ad, the Financier undertakes that if the Customer makes all payments in accordance with the Ijarah Financing Agreement then it will sell the Financier’s interest in the property for a nominal amount (currently $635 which is the current cost of a discharge).
The Ijarah Financing Agreement is also accompanied by a “purchase undertaking” (or Wa’ad) from the Customer. If a Customer terminates early, the Financier will exercise this Wa’ad where the Customer promises to pay the Financier an amount equal to the balance outstanding and immediately purchase Financer’s interest.
From a Shariah perspective, the Customer does not get an incremental share of equity in an Ijarah arrangement. However, as noted in 2.1.9 above, if a Customer terminates early, he must purchase the Financier’s interest in the property for an amount equal to the outstanding balance owing. The “outstanding balance owing” broadly means rental owing, discharge fees and taxes less all payments already made.
To demonstrate how this may work, a Customer may wish to sell the property (with the Financier’s consent) and use the proceeds to pay all “outstanding balances owing” in accordance with the Wa’ad. Practically, the only “outstanding balance owing” comprises the discharge fees, taxes and the remainder of the amount that was applied to purchase the property.
By way of example,
- A Customer used $400,000 of the Financier’s money and applied it to the cost of purchasing the property
- Over 2 years, the Customer has made total rental payments comprising $64,000: (e.g. $40,000 that relates to the amount that was initially applied to the purchase of the property; and $25,000 based on rental rate)
- The Customer now decides to sell the house in the market (with the Financier’s consent) for a market price of $500,000
- Under the Wa’ad he must buy the Financier’s interest which equals the costs of discharge (say $635) plus the balance of rent owing which the Financier sets at $360,000 (e.g. $400,000 being the original purchase price less the $40,000 being the amount already paid)
- At the end of the transaction, the Customer keeps $140,000 which are the net proceeds of the sale after paying the Financier
- It can therefore be seen that the Customer is recognised for prior rental payments made notwithstanding that this is product is not a shared-equity Musharaka
Under principles of Shariah a contract must relate to a single identifiable transaction.
In adapting Ijarah as a mode of financing, Islamic financial institutions need to ensure that multiple contracts are executed e.g. Wakalah, Ijarah and the dual Wa’ad.
The consensus of opinion from Shariah scholars, in this regard, is that so long as there is no contingency between each of the constituent documents (e.g. Each agreement is capable of standing on its own) then this is permissible.
The fact that each contract is signed at the same time is irrelevant. The test is whether each separately identifiable transaction can stand on its own.
The fact that legal title to the property remains with the Customer is irrelevant in considering whether a valid Ijarah relationship exists for the purpose of Shariah.
At first this may seem counterintuitive to the way a conventional lease arrangement may operate. However, as noted in the discussion above, the Shariah will look at the rights and obligations under the terms of the contract to determine whether the relationship between Financier and Customer constitutes a valid Ijarah.
Equally, this rationale also applies to the Wakala and Wa’ad.