Guide to applications and documentation of an Ijarah contract

In-Depth Analysis

The Ijarah structure is used by Islamic banks in a wider perspective which includes retail banking, wholesale banking, capital markets, and asset management. On the retail banking side, an Ijarah contract plays an important role in financing individuals' need to acquire residential premises. This is the Islamic alternate to a conventional mortgage facility. When a retail customer approaches a conventional bank with a request to grant him or her the home mortgage facility, after the successful completion of the customary requirements, the conventional bank grants an interest-bearing term loan facility equal to the funding needs of the customer. The conventional bank does not purchase the property but disburses the loan to the customer and the funds are credited to the customer's current or savings account. The bank commences the charging of the agreed rate of interest on the disbursed amount from that day onwards. In order to prevent the customer from misusing the loan proceeds, the bank simultaneously debits the customer's account and makes a manager's crossed cheque in favor of the property seller. Upon the receipt of the bank's cheque at the land registry department, the seller facilitates the transfer of the property title in the customer's personal name on the completion of the sale and purchase transaction. The conventional bank obtains a mortgage over the property in favor of the bank as security for the term loan. In a nutshell, in this example the conventional bank is simply lending an interest-bearing loan to the customer, similar to any other loans such as personal loans, car loans or credit cards. The registered mortgage in favor of the bank is something over and above the lending and borrowing transaction and is not the core transaction between the customer and the bank. Once the customer has been found eligible for the Ijarah financing, the Islamic bank will not disburse any term loan to him or her in the account. Instead, the Islamic bank will directly purchase the property in the name of the Islamic bank. The Islamic bank shall directly acquire its ownership by making payment to the seller before the land registry department and obtaining the title deed in its own name. This eliminates the need to obtain a registered mortgage since the property is in the bank's own name. Having acquired the property title, the Islamic bank shall start the lease for a defined period of time whereby the customer shall pay a certain amount to the Islamic bank on a periodical basis which is termed as rent. The agreed rent shall continue to be paid by the customer to the Islamic bank until the successful completion of the lease term. What if the customer defaults in payment of any rental during the lease term? The standard Shariah position in such a situation is that, being the lessor, the Islamic bank shall provide extra time to the customer to pay the defaulted rent without charging any additional amount as opposed to a conventional bank's penalty. And what if the property gets damaged or destroyed during the lease term? These questions are addressed in subsequent articles.