The various types of ijarah and how they can be used to finance purchases

A crucial component of ijarah is that the lessor maintains ownership of the asset being leased throughout the duration of the contract period with automatic ownership transfer clauses in the contract being strictly forbidden.

This differs from other forms of conventional leasing whereby the ownership can be transferred to the lessee at the end of the period. The reason behind this is to maintain the liabilities and responsibilities by both parties without confusion, as well as preventing any lease interest expenses being charged by the lessor.

This begs the question: How then can ijarah be used as a form of finance?

There are mechanisms whereby the tenant can obtain ownership of the property at the end of a lease period using the different types of ijarah contracts, which we’ll go over below. 

Read more about : How ijarah differs from conventional leasing?

What are the different types of ijarah contracts?

1- Ijarah thumma al bai (purchase ijarah)

This is one of the most common forms of using ijarah to purchase an asset, and usually stands as a shariah-compliant substitute for a mortgage.

It involves the signing of two contracts: A standard leasing or renting Ijarah over a fixed period; and a separate purchase agreement that triggers the sale upon completion of the ijara.

The process of acquiring an asset though this typically goes as follows: 

·        Step 1: the lessee finds an asset or property they wish to purchase and then negotiates the price of the asset, with provisions for their bank to step in as a buyer.

·        Step 2: The bank purchases said asset, then signs a sale agreement for it with the lessee at a fixed price.

·        Step 3: A separate ijarah agreement is signed that allows the lessee to use the property. The lease or rent payments will be held by the bank as deferred payments towards the purchase of the asset.

·        Step 4: Ownership of the asset is then transferred to the customer after the ijarah is concluded.

2- Ijarah wa iqtina (lease and ownership)

This form of ijarah is very similar to an ijarah thumma al bai – particularly when it comes to signing separate agreements for the purchase and the lease – and usually follows the same steps, with some notable exceptions:

·        - Purchasing is an option: Unlike an ijarah thumma al bai, an itjarah wa iqtina gives the lessee the option to purchase the asset, but does not require them to take ownership (and hence the responsibility) of the asset.

·        - The timing of the ownership transfer: Ownership of the property can be transferred to the lessee at any point during the lease agreement if they are willing to make the outstanding ijarah payments.

·       -  Methodology of transfer: The lessor (in this case the financing bank) may transfer the property either as a gift or through a purchase sale at a nominal value.

This form of ijarah affords the lessee much greater flexibility than the an ijarah thumma al bai, and is ideal in a situation where they would like the option of a purchase but not the obligation. 

3- Ijarah Mawsoofa Bi Al Dhimma (forward ijarah)

This form ijarah differs from the rest as it is a type of lease agreement whereby the leased asset hasn’t been built or constructed yet or the lessor doesn’t yet own the asset. The process for acquiring the asset is as follows:

·        Step 1: The financier / lessor (usually the bank) enters into an Ijarah Mawsoofa Bi Al Dhimma with the lessee / buyer, whereby the contract specifies the service and the type of asset involved including type, quality, and quantity of the asset to be leased.

      The lease will factor in the cost of constructing or procuring the asset in addition to the profits of the lessor.

·        Step 2: The lessor agrees to finance the construction or purchase said asset at the quality type specified. The lessor may appoint the lessee to supervise the construction of the asset or oversee its procurement.

·        Step 3: The lessor completes the acquisition and makes delivery of the asset to the lessee. Only then will the latter begin making the payments towards their lease.

·        Step 4: A purchase agreement in a manner similar to the previously noted ijarah contracts can be signed separately giving the lessee the option to own the asset.

This form of ijarah is ideal to fund the construction and purchase of real estate, which combined with an istisna (manufacturing contract), make it ideal for project financing. 

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