Chapter 2: Permissible Financing Methods

Most types of trade (buying and selling) are permitted in Islam, where prohibition is the notable exception. Yusuf 'Ali (1991) translated the meaning of [2:275] thus: ^{[Note: The English reader may take the term "usury' to mean exorbitant interest, as most contemporary dictionaries would indicate. As seen in the previous chapter, Riba (a term for which no contemporary English translation would be accurate) is strictly forbidden regardless of how small or large the interest rate may be.]}

Those who devour usury (riba) will not stand except as stands one whom the Evil One by his touch hath driven to madness. That is because they say: by is like usury', but Allah hath permitted trade and forbidden usury.

Thus, "Allah has permitted trade" (hay`) is the general rule, with Riba sales being a strictly forbidden exception.

A valid trade is concluded in Islam if the seller and buyer exchange an offer and acceptance which specify the object of sale and the price, and they both agree. Yusuf 'Ali (1991) translates the meaning of [4:29] thus:

But let there be among you traffic and trade by mutual good will.

Al Bayhaqi and 'Ibn Majah narrated on the authority of 'Abu Said AlKhudriy that the Messenger of Allah (pbuh) said (translation of the language in 'Ibn Majah):

I shall meet Allah before I give anyone something owned by another without his consent, for a trade requires mutual consent.

Not only is trading permitted, it is encouraged. Al Suyuti mentioned in Al Jami` Al Saghir, a Hadith on the authority of Rafi` that:

The Prophet (pbuh) was asked: "which are the best forms of income generation?" He (pbuh) replied: "A man's labor, and every legitimate sale"".

Therefore, any financing conducted through valid trading by mutual consent is permissible. However, since most Muslims (myself included) lack sufficient knowledge regarding the various conditions for a sale to be valid, contemporary ,jurists and financial practitioners have limited Islamic banking and finance to a few "named" contracts. Those are contracts that have been studied extensively by jurists over the centuries, and whose validity is well established through the Prophet's (pbuh) own actions (Sunnah), or consensus of the early Muslim communities and jurists ('ijma`). To further add credibility to the industry, the Arabic names for those contracts are often used instead of their English counterparts (e.g. the term 'ijarah is often used instead of its English counterpart "lease''). In what follows, I shall review the most commonly used contracts in Islamic finance, utilizing both their Arabic and English names.

Cost plus sales (murabaha)

In this sale, the buyer knows the price at which the seller obtained the object to be financed, and agrees to pay a premium over that initial price. It was narrated that 'Ibn Mas'ud (mAbpwh) ruled that there was no harm in declared lump sum or percentage profit margins. Thus, one may approach an Islamic financial institution and say "purchase this item on my behalf at this price, and I shall give you a profit ('urbihuka) margin of $10", or "purchase this item on my behalf at this price, and I shall give you a profit ('urbihuka) margin of 10%". The fact that the latter statement may be perceived to make explicit a percentage ^{[Note: Or "interest rate", if a time factor is present as we shall see in the next section]} payment should not be of concern, since it is not Riba if the sale satisfies the conditions of murdbaha. ^{[Note: The faulty use of the contemporary term "interest" as a translation of the term Riba has led to many misconceptions. Bank interest is certainly the forbidden Riba (please see the long discussion of this point in Section 5.2 below). However, just because a profit margin in a valid sale is stated as a percentage does not mean that it is Riba. Stating it as a percentage only requires simple division of the profit margin by the original price, followed by multiplication by 100! In fact Jordanian law on murabaha; dating back to Ottoman Law in 1903, explicitly states a maximal interest rate of 9% in murabaha]} Notice that in this contract, the Islamic bank or financial institution must own the item at the time the customer buys it from them with the specified profit margin.

Credit sales (bay' bi thaman 'ajil)

Very rarely is murdbuha used by Islamic banks with the price paid immediately by the customer. In such cases, there would be no financing included, and the Islamic bank would simply be a middle man or broker agent (simsar). When a customer approaches an Islamic bank to finance a purchase through murabaha the payment of the price is usually deferred, and most commonly paid in installments. ^{[Note: For Arabic readers, I recommend the excellent short manuscript by Al Misr3 (1997 for all the relevant juristic details of the permission of such sales.]}

In such cases, it is easy to look at the end result and assume that this is simply a juristic "trick" to circumvent the prohibition of Riba. However, this is certainly not the case. Indeed, the murabaha component determines a profit margin (even as a percentage of the original price), and the deferment ensures that this profit is collected over a period of time. The rate of return is thus guaranteed (up to the risk of default on payments by the buyer) over a fixed period of time. Twenty some year old misconceptions in the literature on Islamic banking would argue that this makes the banks' profits a form of Riba. However, it is curious to note that some of the proponents of this view in the 1970s were themselves the pioneers of the field of Islamic banking in the Arab Islamic countries and elsewhere. Those banks dealt almost exclusively in the early years in instruments such as the one considered here (and leases to which we shall turn shortly). It was only a matter of time for sophisticated observers to note that those banks' rhetoric contradicted their actions. This early confusion about Islamic banking and finance continues to plague the immigrant Muslim community in North America to this day.

Perhaps the source of the confusion is precipitated by the conjunction of the deferment of the price payment and the profit rate. A seventh grader can calculate the implicit annual interest rate in such a contract. However, traditional Islamic jurists over the centuries have indeed permitted such a conjunction of increase with deferment. In fact, they have explicitly justified the increase by the deferment. Al Misri (1997, pp.39 44) lists a number of quotes by traditional jurists of various schools, illustrating the permissibility of increasing the price based on deferment. Sonic jurists qualified this permissibility with conditions to ensure that other reasons for prohibition (e.g. two sales in one, a sale and a condition in one contract, etc.) were not present.

I shall only list a few of the quotations included in the above teat to illustrate that increasing the price due to deferment is indeed permissible:

The contemporary confusion is hardly new. In 'Ibn Al `Arabi's 'Ahkam Al Quran, he reports a specific argument given by the Arabs during the time of Prophet Muhammad (pbuh) to support their statement that "trade is like Riba" (2:275). They argued as follows: Consider a credit sale, with a price of 10 payable in a month. After a month, the buyer and seller agree to postpone for one more month, and increase the price to 11. The latter is forbidden Riba. They then argued: is this not the same as an initial sale with the price of 11 deferred for two months'? The answer in (2:275) was a decisive "but Allah has permitted trade and forbidden Riba'.

The legal difference between the two is very clear: one is a sale in which price is increased for deferment, and the other is an increase in the amount of a debt for deferment. The first is permitted, and meets almost all the financing needs which can be met through forbidden Riba based lending. The second, however, is strictly forbidden. The permissibility of the first and the prohibition of the second are both quite clear and unequivocal. ^{[Note: The non Arabic readers, who may not have access to the above referenced manuscript by Al Misri (1997), may refer to M. Taqi Usmani (1998, pp.104 109) for clear legal distinctions between the increased price in credit sales and the forbidden interest on loans/debts, as well as some of the technical legal conditions for murabaha financing to be valid.]} Therefore, we may use credit sales as a form of finance, and we must categorically avoid interest bearing loans. Why one is permitted while the other is forbidden can only be fully known by Allah and whomsoever he gave such knowledge. As a practical matter, we should know what is permitted and use it to our advantage, and what is forbidden and avoid it.

Leasing ('ijarah or 'ijar)

Legally, the lease contract is not a, sale of the object, but rather a sale of the usufruct (the right to use the object) for a specified period of time. The sale of usufruct is permissible in Islam, as evidenced by the verses (translation of meaning by Yusuf Ali (1991)):

And if they suckle your offspring, give them their recompense. [65:6]

Said one of them: 'O father, hire him on wages, for truly the best to employ is a strong and trustworthy man'. He said: `I intend to wed one of my daughters to you, on condition that you work for me for eight years, and if you complete ten full years, that will be a grace from you'. [28:26 27]

It is also established by the following Hadith narrated by ' Ahmad, 'Abu Dawud, and Al Nasa.'i on the authority of Sa'd (mAbpwh):

The farmers during the time of the Prophet (pbuh) used to pay rent for the land in water and seeds. He (pbuh) forbade them from doing that, and ordered them to use gold and silver (money) to pay the rent.

Also, 'Ahmad, Al Bukhari and Muslim narrated on the authority of 'Ibn 'Abbas (mAbpwh) that the Prophet (pbuh) hired a man to cup [water] for him, and paid him his wages.

There are a number of conditions for lease financing to be valid (the interested reader may refer to M. Taqi Usmani (1998, pp. 157 174) for a partial list). The most important financial difference between Islamically permitted leasing and conventional financial leasing is that the leasing agency must own the leased object for the duration of the lease. Therefore, while leasing an automobile from a car manufacturer or dealership may in principle be permitted (if the contract satisfies the other conditions), Muslims should be careful. In many cases, the dealership will in fact use a bank or other financial intermediary to provide a loan for the present. value of lease payments, and charge the customer an interest on this loan. This would constitute the forbidden Riba. Careful Islamic, financial institutions ensure that the contract abides by all the restrictions set in the Shari`a (e.g. sub leasing requires the permission of the lessor, late payment penalties must be handled very carefully to avoid the forbidden Riba, etc.).

Recently, Muslim jurists have also provided an Islamic alternative to conventional lease purchase agreements (called in Arabic 'ijarah wa 'iqtina'). In this contract, a lease is written as discussed above, with an additional promise by the lessor that he will agree to sell the leased object at the end of the lease at a pre determined residual value. This promise is binding on the lessor only, and the lessee has the option of purchasing the item at the end of the lease, or returning it to the owner lessor (c.f. ibid. (pp.l75 6)).

A common model for equipment, auto and home financing in North America is based on leasing or lease purchase. The Islamic financial institution buys the financed object, and retains the title through the life of the contract. The customer makes a series of lease payments over a specified period of time, and may have the option at the end to buy the item from the lessor (and owner) at a pre specified residual value. The period of the lease and the rent payments may be made such that the final payment is only symbolic.

It is no secret (at least it should not be a. secret) that the Islamic bank or financial institution will take into consideration the same factors when determining the rental payments and residual value that a regular bank would consider: the value of the financed item, its depreciation value, inflation, the credit worthiness of the lessee, the opportunity cost value of the money (as reflected by market interest rates)., etc. of course, an implicit '`interest rate" can trivially be calculated from the price, residual value, term of the lease and the lease payment. There is no need to hide this fact, and indeed, the intelligent Muslim customer (as Muslim customers should always be) must be encouraged to "shop around" and ensure that the Islamic financial institution is not implicitly charging an interest rate which is not in line with the conventional market. However, in the final analysis, the difference will be in the form of the contract. If the lease is structured in accordance with the various conditions detailed in books of jurisprudence, it will contain no Riba and will ensure that it cannot contain such forbidden Riba in the future (e.g. in terms of late payment fees, etc.) .

Partnerships (musharaka and mudaraba)

Various forms of partnership can be direct financing methods. In the early days of Islamic banking and finance, those forms were commonly grouped under the banner "profit. and loss sharing", to be contrasted with the above listed debt based forms of financing. It was assumed by some that the profit and loss sharing methods were somehow more ideal from an Islamic point of view. The fact that most Islamic banking practice concentrated on credit sales and leases was thus often lamented as re labeling of the forbidden interest. As we have already seen, if the Islamic banks and financial institutions are careful to abide by the rules of Shari`a, there is no reason to think that credit sales are any "less Islamic" than a silent partnership (mudaraba) or full partnership (musharaka). ^{[Note: Still, respected ,jurists as well as many Islamic economists, while admitting the permissibility of debt based financing, continue to echo such sentiments. For instance; M. Taqi Usmani (1998, pp.239 240) states: "The ideal instrument of financing according to the Shariah is Musharakah where the profits and losses both are shared by both the parties according to equitable proportions". This opinion is not based on any solid juristic or religious evidence, but rather based on the jurist's economic reasoning (ibid): "Musharakah provides better opportunities for the depositors to share actual profits earned by the business which in normal cases may be much higher than the rate of interest. Since the profits cannot be determined unless the relevant commodities are completely sold; the profits paid to depositors cannot be added to the cost of production, therefore, unlike the interest based system the amount paid to depositors cannot be claimed back through increase in the prices". It is important for the sophisticated reader to distinguish between the jurists' opinions which are based on solid religious grounds, and those based on inadequate economic reasoning.]} There are a number of rules in Shari'ah regarding the language of the various partnership contracts, the rights and obligations of various parties, and the sharing rules for profits and losses.

Most of the users of such partnership contracts will require the services of legal experts in any case, and therefore should also consult Islamic legal experts on the legitimacy of any specific contract. Therefore, there is no need to spend much time on those general contracts.

However, one model of financing which has been used in North America is based on a form of musharaka, where the financing agency and the customer share the ownership of real estate. This contract is known by many names, most prominent among them is the name musharaka mutanaqisah (diminishing partnership). In contrast to the leasing model, where ownership of the financed item remains with the lessor for the entire lease period, ownership in a diminishing partnership is explicitly shared between the customer and the Islamic financial institution (legally; what is established is an Islamic sharikat al milk). The periodic payments of the customer in this model contain two parts: (i) a rental payment for the part of the property owned by the Islamic financial institution, and (ii) a buy out of part of that ownership. Over time, the portion of the asset which is owned by the customer increases, until he owns the entire asset and needs to pay no more rent. At that time, the contract is terminated.

Examining the periodic payments, the customer will find that they look very much like a conventional mortgage schedule. Early on, a large portion of the payment is "rent" (corresponding to "interest payment" in conventional mortgage), and a small part is "buy out" (corresponding to the "principal payment" in a conventional mortgage). As time progresses, the first component gets smaller, and the latter component gets bigger, until the rent becomes zero when the customer owns 100/0 of the asset. Given this one-to one correspondence between the two components of the payments, it is again trivial to calculate the equivalent interest rate which would make the conventional mortgage payments identical with the diminishing partnership payments.

Again, this should not be cause for concern, as long as the partnership contract is written in full accordance with the rules of Shari `a (for a partial list and general discussion, see M. Taqi Usmani (1998, pp. 31 92)). For instance, there is a fundamental difference between a mortgage company which holds a lien on a financed house, and the actual joint ownership of the house between the client and the Islamic financial institution. There are a variety of issues which such institutions need to resolve to operate in compliance with Shari `a as well as government regulations, and the intelligent Muslim customer is again encouraged to ensure that both sets of regulations are met. As for the correspondence of the "rental" portion of payments to what would be an interest payment on the principal balance in a conventional mortgage, this should afford the intelligent Muslim customer an opportunity to ensure that he is not being charged excessively relative to the conventional market. As far as compliance with the Islamic Shari `a is concerned, the form of the contract is what matters. To keep the Islamic financial industry from reeping excessive profits at the expense of devout Muslims with few alternative sources of financing, this comparison to conventional market trends is very valuable.

Islamic forwards (salam and 'istisna')

Those forms of financing are very rarely used, and hence will be mentioned only in passing. In general, the sale of non existent objects is forbidden due to Gharar. However, to facilitate certain types of business, exceptions were given through those two contracts. The six major books of Hadith narrate on the authority of 'Ibn 'Abbas (mAbpAh):

The Messenger of Allah (pbuh) came to Madinah, and found its inhabitants entering salam contracts (with the price paid in advance) in fruits for one, two, and three years. He (pbuh) said: "whoever enters into a salam contract, let him specify a. known volume or weight., and a known term of deferment".

Thus, he (pbuh) permitted this trade, where the price is paid in full, and the well defined object of the sale is delivered after a specified time. This pre payment of the price allowed the farmers to buy seeds, spend for their own sustenance, etc., in order to be able to produce the fruits.

Most jurists reasoned by analogy (qiyas) and preference ('istihsan) from the permissibility of salam to the permissibility of 'istisna', which may be translated as "commission to manufacture". In the latter contract, the price is paid in installments as the work progresses in manufacturing or building an otherwise non existent object. The price pre paid in installments in this case will often be lower than the cost of purchasing the finished product (if it were to exist), and can therefore be a useful tool for building schools, Masjids, etc.

Those two contracts are permitted as exceptions to the general rules of sale. As such, there are many conditions which must be met for salam or 'istisna' contracts to be valid. Those considering the use of such contracts are advised to consult an Islamic Legal expert along with their other lawyers to ensure that they abide by Shad `ra as well as government, regulations.