IJARA / IJARAH also known as Lease-to-Own – Understanding Islamic Finance
Translated literally, Ijara means rent and is applicable to both property and equipment. Ijara-wa-Iqtinais a straight forward Sharia method meaning rent with an acquisition or a rent-to-own process. With the creation of a bare trust around a single asset, the property is purchased by the Trust and then leased to the customer. A share of the monthly payment goes toward the customer gaining 100% ownership. Under Ijara, the Trust or seller is obligated under the terms of a Promise to Purchase contract to sell the property to the customer, however the customer is not bound to purchase the property, making a Sharia compliant Ijarah-wa-iqtinah method different from a traditional lease.
HOW TO DETERMINE THE PURCHASE PRICE IN AN IJARA TRANSACTION
The price agreed upon in the Promise to Purchase contract equals the initial purchase price, minus the customer’s down payment, plus the sum of One ($1.00)Dollar. If, for example, the property is valued at $200,000 and the customer pays a down payment of $40,000, then $160,001 is the amount the client owes the investor to gain 100% ownership of the property. As this outstanding amount declines, the customer’s ownership in the property increases, with final ownership obtained with the payment of One ($1.00)Dollar.
HOW MONTHLY IJARA RENT PAYMENTS ARE CALCULATED
The investor earns profit on the initial Ijara amount financed by the customer through monthly rental payments. Standard amortization calculations, acceptable because there are no Sharia issues with mathematical formulas, are used to determine specific monthly payments. The Ijara transaction is formulated on a reverse amortization calculation setting it apart from a conventional mortgage amortization.
HOW A PERCENTAGE WORKS
Rather than contradicting Sharia, using percentages to explain the gain made on an Islamic transaction is acceptable. Measuring the benefit as a percentage in an Ijara transaction is best explained in the following example:
- Assume you have cash in the amount of $100,000
- You apply this cash toward the purchase of a home
- You charge a tenant $500 monthly to rent the property
- At year’s end, rental payments of $500 collected over 12 months total $6,000
- Total rent of $6,000 represents a return of 6% on your initial investment of $100,000
If you are wondering whether the 6% represents Riba or Rent, the obvious answer is Rent because the percentage results from a business agreement. Let’s compare this to a conventional mortgage interest undertaking:
- Starting out with the equivalent amount of cash being $100,000
- You transfer this cash amount to someone
- They use these funds to buy the identical home
- In order to use these funds, they allocate an equal $500 monthly payment to you representing 6% per year
- This formula basically means rent on the funds
In the latter instance, the 6% represents rent on funds or Riba. Therefore, using a percent to describe the profit gained from an Islamic Ijara transaction is acceptable from a Sharia viewpoint. In addition, the Truth in Lending Act/Consumer Protection Act requires any profit gained from a residential realty transaction must be set out as a percentage so the customer can evaluate the total cost of the financial transaction.
TO RENT OR OWN
A participant in an Ijara transaction is deemed to be a tenant and as such you execute a lease obligating you to pay rent for a specific term. The difference between this type of lease and a conventional lease where you rent property is that you possess the rights and responsibilities of a homeowner including maintaining the property. You are allowed to decorate, remodel, landscape or use the property for legal purposes pursuant to the zoning regulations, including subletting or selling the property at any time, save and except an activity that could negatively affect the property value such as tearing down a garage without rebuilding a new structure. To all intents and purposes, your function is equal to a homeowner since your accountability under the lease or promise to purchase entitles you to ownership of the property.
SHARING A LOSS OR GAIN
Sharing either a loss or gain in a financial transaction is a fundamental principle of Sharia compliance. As a result, the Ijara undertaking is set up to reflect the entire gain or 100% rightfully belongs to the customer. Under Shariah, parties share loss or gain in a transaction based on their percentage of ownership. Abiding by this doctrine and at the time of realization of loss or gain, the Ijara transaction recognizes the customer as the only property owner.Procedural steps undertaken at the time of the sale will include:
- transferring title to the property from the Trust to the customer,
- transferring title from the customer to the purchaser,
- settling the transaction with the purchaser pursuant to the terms of the agreement with the customer,
- lastly, allowing the customer to conclude with the trust pursuant to the terms of the arrangement (or the Ijara documents) between the customer and the trust.
Creating a scenario in which the customer holds 100% title to the property even briefly, the aforementioned procedural steps entitle the customer to benefit from the dissimilarity between the two agreements; one being the initial promise to purchase arrangement with the trust, and the other being the sale to the purchaser.