Qard Hasan – A Benevolent Loan
February 3, 2018Murabaha – Cost Plus Sale
February 5, 2018Mudarabah and Musharakah are the preferred methods of interest-free financing. However, they are not well suited for modern day acquisition of property and other tangible assets. The Islamic banks want to minimize risk of loss of capital and improve chances of profits. The banks tend to use Murabaha as a cost plus financing method to generate profits. This method is, however, very similar to interest based traditional loan as the bank is almost guaranteed a fixed profit and also tends to increase the cost of financing. Hence, depending upon the structure of Murabaha contract its Shari’ah compliance could be doubtful. The other option is Ijara (lease) which is suitable for certain transactions but only when the customer wishes to only to use the asset, does not seek ownership and the bank is willing to take the risk of financing a lease.
As an alternate, a Shari’ah compliant modified partnership, Diminishing Musharakah (DM) has been developed by Islamic banks. It is a hybrid of Musharakah and Ijara which are both riba free contracts. If a customer needs capital for a definite period of time to acquire an asset or to make an investment, yet wants to avoid borrowing money on interest, can go into a DM mode of financing with the bank. DM is also helpful for those customers who are not looking for a perpetual Musharakah with a financial institution. DM contract consists of an agreement where the bank and the customer go into a joint ownership of an asset, and customer leases part of the asset that is owned by the bank. Since interest is prohibited in Islam and collection of rent is allowed, the bank earns profit on the share of partnership that it owns. The customer keeps paying rent on the bank’s share while making additional payments to the bank to acquire the entire asset. The customer avoids borrowing on interest while the bank generates riba free profits. The risks in DM are relatively lower since the bank still owns its share in the venture until it is paid off.
DM consists of various independent contracts which are all Shari’ah compliant as long as they are not dependent upon each other. The first part of a DM contract is a traditional Musharakah (partnership) where both parties contribute some capital, and agree to share profit and loss. The second component is Shirkah al-Mulk where a partnership is formed to acquire joint ownership of an asset or an investment. The third part is a lease agreement in which the financier leases out his portion of the investment to the other partner for an agreed upon rental value. Lastly, an agreement allows the customer to buy off the bank’s portion over time. Each agreement is separate and stands on its own, which is a requirement of Shari’ah.
Diminishing Musharakah (DM) is a series of contracts which will be explained and demonstrated with an example of a house purchase for the price of $500,000.
The first step is the raising of Musharakah capital by both the bank and the customer. The ratio is based on the requirements of the bank for these contracts. In this example the ratio is 80:20. The bank provides 80{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} capital which is $400,000 while the customer, also known as Resident Owner (RO) contributes 20{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} or $100,000. The bank and the RO become co-owners of the house in the partnership.
Then, the RO promises to buy the financier’s share over time and the latter agrees to sell his share. The buyout period and frequency of payment is determined at the time of contract. In our example, the time is 11 years and the RO agrees to acquire the property by making annual payments starting in second year towards the buyout. The annual buyout payments are set as ten units of $40,000 each, reaching the full amount of $400,000 in ten years. In actual contracts, the payments are usually set monthly. We are using annual payments for simplicity. Though Shari’ah requirement is to determine the market value for each unit that is sold, the scholars have allowed the use of sales contract price. This is due to practicality of having a determined price, to avoid uncertainly (gharar) in the sales price of each share, and also the uncertainty in lease value of the bank owned share.
The RO will also make lease payments to the bank on the portion of the house owned by the bank. This lease payment portion of the payment will decline over time while the buyout will rise as the RO owns a bigger and bigger portion of the house. The fair market rent at the location is about 1/2{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} per month or 6{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} annually. The initial rent will start at $24,000 which is 6{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} of the bank’s 80{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} ownership at $400,000. In actual contracts, expenses for insurance, maintenance, and taxes also need to be accounted for. The RO or the bank adjusts this amount from the monthly payment and pays it directly on behalf of the partnership. We have not taken these into account to keep this example simple.
The profit and loss are shared between the owners. The bank earns its share through the rental while the RO saves the rent on his portion of the house, which is his profit. If the contract is terminated prematurely, any appreciation in the property value will be shared according to the ownership ratio at the time of sale. In case of a default, the property could be wholly repossessed by the bank or liquidated. If the proceeds are less than the bank’s share, the bank will suffer that loss while the RO loses his share of the ownership.
DIMINISHING MUSHARAKAH EXAMPLE
| Year | Payment | Bank | Bank {decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | Rental | RO | RO{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 1 | 0 | $400,000 | 80{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $24,000 | $100,000 | 20{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 2 | $40,000 | $360,000 | 72{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $21,600 | $140,000 | 28{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 3 | $40,000 | $320,000 | 64{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $19,200 | $180,000 | 36{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 4 | $40,000 | $280,000 | 56{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $16,800 | $220,000 | 44{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 5 | $40,000 | $240,000 | 48{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $14,400 | $260,000 | 52{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 6 | $40,000 | $200,000 | 40{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $12,000 | $300,000 | 60{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 7 | $40,000 | $160,000 | 32{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $9,600 | $340,000 | 68{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 8 | $40,000 | $120,000 | 24{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $7,200 | $380,000 | 76{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 9 | $40,000 | $80,000 | 16{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $4,800 | $420,000 | 84{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 10 | $40,000 | $40,000 | 8{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $2,400 | $460,000 | 92{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
| 11 | $40,000 | $0 | 0{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} | $0 | $500,000 | 100{decebffaf8f25eb0a85c221f62bbc22c324e812b773b74c7945f3fd99473db6b} |
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[…] There are three major players in the US for Sharia Compliant Financing. Riba free or interest free does not mean there is no cost to borrowing. These finance companies need to be compensated or they won’t stay in business. In order to refrain from traditional interest based mortgages, each one has developed some flavor of lease to own system, referred to Islamic Finance as Diminishing Musharakah. […]