In the previous article, we have summarized the important conditions and basic rules of ijarah contract. Today, we are going to learn how the contract of ijarah or Islamic lease is used in modern Islamic financial institutions and Islamic banks. If we look at the products of Islamic banks today, we find the contract of ijarah is very prominent. They offer a number of products based on the concept of ijarah such as home financing, vehicle financing, service financing and sukuk etc.

Basically, ijarah or lease was not used as a mode of financing in its classical form. It was simply used to transfer the usufruct of a property from one person to another person for an agreed consideration. However, leasing is widely used and recognized as a mode of financing in prevalent financial system by conventional banks and corporations.

When Islamic banks and Islamic financial institutions were established in the recent part, they realized that ijarah can be used as Shariah compliant mode of financing and it can be structured as alternative to conventional lease. They started to structure Islamic banking products based on the concept of ijarah in order to fulfill the different needs of their customers. Islamic banks use ijarah to enable their customers to use durable goods and equipment such as ships, aircraft, heavy machines, plants and vehicles. The customers have a luxury to use these durable goods without having to buy them. Usually, the contract of ijarah is for a time long enough to cover the life of the asset. In the following, we shall explain two famous types of ijarah which are used by Islamic banks.

Operating Lease

Operation lease refers to an ordinary lease in which the asset is rent out based on ijarah for a specified period against an agreed return. It’s suitable for those assets that are expensive and their purchase requires a great amount of money. The types of assets given on lease includes aircrafts, ships, industrial equipment and agricultural machines etc. The operating lease is a simple rental agreement where the lessor (owner) leases his asset to the lessee for a specified period and get rental on it as a return of this arrangement. The asset is usually returned to the lessor at the end of the lease period. In Islamic banking and finance, the operating lease has same structure as the conventional finance. However, there are some fundamental differences between both types of lease. In Islamic finance, the operating lease is subject to the rules and conditions of ijarah contract. For instance, the interest is not allowed and penalty clause is not permissible in case of late payment. Likewise, the ownership risks such depreciation of the asset will be borne by lessor who is the owner of the asset.

Financial Lease

In conventional finance, the financial lease is in essence similar to a loan transaction. Because, all the risks related to the asset is passed to lessee and the lessor doesn’t take the ownership risk. Obviously, this concept is not allowed in Shariah to transfer the risk of ownership to the lessee (who is not the owner of the asset). Islamic banks use the contract of ijarah as a Shariah compliant alternative to financial lease. This product generally known as ijarah muntahia bittamleek which literally means “a lease that ends with ownership of lessee”.  Basically, it’s structured based on two contracts: a contract of lease (ijarah) for a specified period and a contract of sale at the end of the leasing period. At the beginning of the ijarah contract, the lessor promises that he shall transfer the asset to the lessee at the end of ijarah contract. This may be done by selling the asset at token price or at market value of the asset. The lessor may promise that he shall give the asset to the lessee if he pays all the rental payments. This arrangement of ijarah is used widely in Islamic banks and approved by various contemporary scholars.

However, there are two conditions which need to be observed in this arrangement.

1. The agreement of ijarah (lease) must be independent and should not be subjected to the promise of sale or gift. The promise undertaking should be recorded in a separated document.

2. This promise should be unilateral and binding on the promisor only. Because, if it’s a bilateral promise and binding on both parties, then it’s equivalent to full contract effected from the future date. That’s not allowed according to majority of scholars.

These conditions are important and necessary to ensure the obligation and liabilities of both contracts are independent and not linked with each other.

Mechanism of ijarah in Islamic banks

1. The customer visits the Islamic bank and applies for leasing facility.

2. The Islamic bank purchases the asset from the supplier and pays the full amount according their bargaining.

3. The customer and Islamic bank enter into ijarah contract in which they agree on terms and conditions of ijarah and specify the period of lease and rental amount.

4. During the period of lease, the title of ownership remains with lessor and the lessee has the right to use the assets.

5. In a normal lease, the asset is returned to lessor at the time of completion of lease period.

6. In the case of ijarah muntahia bittamleek, the ownership title of the asset is transferred to the lessee either thorough sale or gift.