Islamic Banking and Finance - Ijarah

Published: 23rd October 2011
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The Islamic Banking system has structured a number of banking instruments or transactions which serve to fulfill the customer’s requirements while falling within the mandates set up by the Shari’ah Board of Islamic Law. As the giving or taking of interest or Riba is not permitted by Shari’ah Law, strict Islamic rules on financial transactions have been laid down to avoid the practice of Riba. One such popular financial instrument which is permitted by Shari’ah is Ijarah.

An Ijarah is defined as a lease, rent or wage where the Islamic bank leases the use of equipment, building, machinery or other facility against an agreed rental amount for a fixed period. Basically, Ijarah is an Islamic term that means “to hire or lease a physical asset or the services of others against the payment of any rentals or wages”.

In Islamic Finance, the term ‘Ijarah’ is commonly used for two different situations.
- To hire the services of a human being, or Ijaratul Ashkhas
- To lease a physical asset

An Ijarah is different from an outright sale in that in a sale, the ownership of the property is transferred to the purchaser, while in the case of Ijarah, the property remains in the ownership of the transferor. It is only its usufruct i.e. “the right to use it” that is transferred to the lessee. The terms of the transaction must be very clear and no ambiguity is permitted – mainly, the duration of the lease as well as the fee must be set in advance and mutually agreed.

It must be noted that consumable goods cannot become a subject of Ijarah. For instance, items like money, eatables, fuel and so on cannot be leased out, because they cannot be used unless they are consumed. Only items such as equipment, building, machinery or other fixed assets that are not consumed, and whose structure does not change visibly with use, can be a subject of Ijarah.

In Islamic Banking, the Islamic bank assumes the role of an ajir (or lessor) and allows its client to use a particular asset that it owns. The client or mustajir (lessee) who is in need of the asset receives the benefits associated with ownership of the asset against payment of predetermined rentals (ujrat).The asset remains in the possession of the bank during the period of the Ijarah, and the bank must assume all ownership related risks and expenses that fall during that period. The bank calculates its profit margin by determining in advance the cost of the item, its residual value at the end of the lease period and the time value for the money being invested in purchasing the asset for that term period.

One particular instance of Ijarah which is popularly used in house financing is the Ijarah wal-`Iqtina’ . This contract is just the same as that of the Ijarah except that the business owner makes a commitment to buy the equipment at the end of the lease period. The fees previously paid form part of the purchase price.

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