The automobile financing using Islamic contracts

by : Fatima Abalhareth

  1. Introduction

Shop around before you make a decision about buying or leasing. Consider the offers from different dealers and several sources of financing, including banks, credit unions, and finance companies. Comparison shopping is the best way to find both the vehicle and the finance or lease terms that best suit your needs as an example of our project today is a vehicle specifically Islamic Vehicle Financing.

This study will attempt to investigate tow big ideas; first what is the Islamic vehicle financing done with the Saudi Arabia Banks. To achieve the objectives of the study, we shall compare between the conventional finance and Islamic finance, especially on the process of vehicle finance on details. Second, we’ll move to the calculation part which is how Islamic banks in Saudi Arabia provide these services in their contracts to enhance the study.

1.1 The Vehicle financing

The vehicle financing is in direct lending, when get a loan directly from a bank. After the agreement to pay, over a period of time, the amount financed, plus a finance charge. Once enter into a contract with a dealership to buy a vehicle, you use the loan from the direct lender to pay for the vehicle. In Other hand, it is in dealership financing, which is another common type of vehicle financing, getting financing through the dealership, and a dealer, enter into a contract where you buy a vehicle and agree to pay, over a period of time, the amount financed plus a finance charge. The dealer may retain the contract, but typically sells it to a bank, finance company or credit union — called an assignee — that services the account and collects your payments.

Before we buy or lease a vehicle should be attention on these 3 points:

  1. Consider Federal and State Laws. b. Determine How Much You Can Afford. c. Monthly Spending Plan. Also, if we want to lease a vehicle must be considered the monthly payments on a lease usually are lower than monthly finance payments on the same vehicle because you are paying for the vehicle’s expected depreciation during the lease period, plus a rent charge, taxes, and fees. But at the end of a lease, you must return the vehicle unless the lease agreement lets you buy it and you agree to the purchase costs and terms.

However, to determine if leasing fits your situation:

  • Consider the beginning, middle and end of lease costs.
  • Compare different lease offers and terms, including mileage limits.
  • Consider how long you may want to keep the vehicle.

For instant:

Term 3 Years – 36 months 5 Years – 60 Months
Purchase Price $31,000 $31,000
Down Payment (20%) $6,200 $6,200
Amount Financed $24,800 $24,800
Contract Rate (APR) 5.00% 5.00%
Finance Charge $1,958 $3,280
Monthly Payment Amount $743 $468
Total of Payments $26,758 $28,080

 

  1. Difference between Islamic & Conventional Financing

The basic difference between Islamic Banking and conventional banking is the contractual relationship. This fundamental difference posed a totally different outlook on what happens after that. The contract between a customer and a conventional bank is simple; a loan where interest is charged upon. But look at an Islamic contract. The contract defines the relationship, the responsibilities, the subject matter, and the sequencing and ownership requirements for the use in an economic transaction. However, the transaction explains the rewards and returns on the completion of the contractual obligation by the regulators of the Shariah Committee; Cause and effect, risks and compensating return, action and rewards. The deployment of Islamic Banking funds is not for charity. It is still a business that should not charge interest. Moreover, the return on Shareholder capital is also important to ensure that capital is continued to be invested into Islamic Banking for it to grow. With growth comes the ability to continue supporting the ummah, the Muamalat defined within Shariah-compliant transactions. The main difference between Islamic Banking and conventional banking is that the concept of justice to customer is not regulatory driven; it is conceptually driven by the idea of Islamic Banking itself. A lot of conventional banking practices are developed to maximize returns while minimizing risk and risk-transference is a key consideration for conventional banks. Regulators have to be vigilant to ensure conventional banking to the line to protect customer’s interests.

  1. ISLAMIC VEHICLE FINANCING Vs CONVENTIONALVEHICLE FINANCING

With the increasing demands of everyday life, vehicle ownership has shifted from a mere luxury to a vital necessity. Purchasing a car is often the second most expensive, yet important purchase, after buying a home. While doing so, an individual has two options available: either to make a hand on hand (cash) purchase or to go for Vehicle financing. However, due to the exorbitant car prices and lack of the funds available, many individuals prefer the latter option and approach the various financial institutions, which provide this facility at different rates.

Vehicle Ijarah’ has been designed according to the principles of Islam and is completely interest-free. Moreover the Ijarah contract and other documentation also comply with Shariah requirements. On the other hand, a conventional car-financing scheme is actually an Interest based loan given by the financial institution and interest is charged on that loan. Also, in conventional car-leasing arrangements, the lease contract is not in compliance with Islamic Shariah and has Riba and other un-Islamic elements in it.

In ‘Car Ijarah’ the asset remains in the ownership and risk of the bank and the customers only pay the rentals for use of the asset; just like house rent. These basic differences are described in detail as the first term is (leasing or financing) that traditional systems provide financing for purchasing car, i.e. In essence, they are giving loan and earning interest. The Islamic car financing – It is not a financing scheme rather it is a lease contract. Ijarah is based on a lease contract. It is not a mixture contract. IJARAH is an Arabic term with origins in Islamic Fiqah, meaning to give something to rent. Leasing is a contract are transferred from the lessor, to another person is the lessee, at an agreed-upon price called the rent, and for an agreed-upon period of time called the term of the lease that is a second term (rental or installment).

Also, the term of (down payment or security deposit) that is in Ijarah the buyer is required to keep a security deposit at the bank. The minimum requirement for security deposit is 20% of the car value and the maximum is 50%. The requirement is different in the case of conventional car financing is a down payment made by the buyer of the car. The amount required for the down payment is 20% of the price plus the installment for the first year. Both the down payment and the security deposit mentioned above are one-time payments. However, the return in the Islamic mode of financing, the buyer has the right to return the car anytime during or at the end of the lease period, but in a conventional car financing the customer cannot return in any case.

  1. The Contracts used for Islamic Vehicle financing

-Murâbaḥah contract; the seller informs the buyer of his cost of acquiring or producing a specified product. The profit margin is then negotiated between them. The total cost is usually paid in installments.

-Ijārah (Lease, lease purchase); A party leases a particular product for a specific sum and a specific time period. In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.

Ijārah and murâbaḥah have many similarities and differences. In both financing modes, the bank is not a natural owner of the asset, but acquires it upon receiving a request from its client. Like murâbaḥah, ijārah rentals are paid in installments over time, and are supposed to cover the cost of the asset or the value of an investment for the bank and to provide a fair rate of return on investment. Thus, both contracts create debt. However, in murâbaḥah, the benefits and risks of ownership of the asset are transferred to the client along with ownership, ijārah rentals can be made flexible to reflect changing vehicle business conditions, especially if the rental period is very long. Murâbaḥah and ijārah are easily understood because of their close similarity to conventional financing (installment sales and leasing). Other contracts as Salam (Prepayment, deferred delivery) the buyer pays the seller the full negotiated price of a product that the seller promises to deliver on a future date.

-Istisna’ (Deferred payment, deferred delivery) A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The price does not have to be paid in advance (in contrast to Salam). It may be paid in installments or part may be paid in advance with the balance to be paid later on, based on the preferences of the parties.

-Salam and istisna’ are less frequently used debt-based Islamic financing instruments that do not meet the condition of physical possession of the asset for sale; these are the only two exceptions to the principle that one cannot sell a commodity before it comes into existence.

There are four main differences between istisna’ and salam contracts. (i) istisna’ involves the sale of unique manufactured goods as opposed to salam that can be used in standardized goods. (ii) Unlike salam who requires the payment of the full price up front, istisna’ allows for spot, deferred, or even installment payments. (iii) An istisna’ contract can be cancelled unilaterally until the date that the manufacturer starts working on the goods, while the salam contract can be cancelled only before the contract signature. (iv) The time of delivery is fixed in salam, whereas istisna’ can specify a maximum time for delivery after which the purchaser is no longer bound to accept the vehicles.

  1. Islamic vehicle financing by Five Saudi Arabian banks and their products

— Al Rajahy Bank, Car Ijarah is simply a rental agreement under which the car is given to the customer on rent for a period agreed at the time of the contract. The customer is required to deposit an initial amount (security deposit) with the Bank. Upon completion of the lease period the customer has two options, either to return the car and take away the security deposit or take ownership of the car against his security deposit or any other agreed amount via separate sale transaction.

— Bank Al Riyad, Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.

— The National Commercial Bank (NCB), Murabaha is a Shariah-compliant form of financing where the Bank, based on requests from its customers, purchases specific commodities and sells them to the customers at an agreed-upon price equal to the Bank’s cost plus a specified profit margin, which is payable on a deferred basis in agreed-upon installments. The main uses of Murabaha are in residential, commercial real estate, and trade finance.

— Arabi N Bank, Istisna’a is a contract for the acquisition of assets to be manufactured in accordance with the specifications of the one who requests the assets to be manufactured / procured. In this product the Bank can either be the manufacturer/ procurer (Saani) or the party who is seeking the assets to be manufactured/procured (Mustasni). In project finance, the Bank takes the role of Mustasni and agrees with the customer to deliver specified assets for an agreed upon price. The Bank pays for the asset in staged payments. At the same time, the Bank enters into a forward Ijara and leases the assets to be created to the customer with promise to transfer ownership.  The main use of Istisna’a is in project finance combined with forward Ijara to finance the construction of new projects.

–Bank Al Balad, All the above Shariah-compliant financing products are accounted for in conformity with the accounting policies described in these financial statements. They are included in the financing and advances.

  1. Case Study

All banks apply the simple interest formula to calculate the total amount of the loan, then divide the total amount by the number of months. Example: Loan amount is 100000. The profit margin percentage rate is 2%. Number of financing years is 5. The total loan with profit margin is 100000* (1+2%*5) =110000. Monthly installments equals 110000/60=1833.33

Risk Management; in addition to facing common risks with conventional financial institutions, Islamic banks also face their own unique risks. The Shari’ah-compliant nature of assets and liabilities distinguishes them from conventional banks while at the same time exposing them to similar market, credit, liquidity, operational, and legal risks. Notably, differences in opinion among equity risk arise when Islamic banks enter into musharakah and mudârabah partnerships, as providers of funds and they share in the business risk of the activity being financed.  The mark-up risk tends to rank highly for Islamic banks. However, All in all, profit-sharing investment accounts (PSIA), diminishing musharakah, mudârabah, Salam, and istisna’ tend to be considered riskier than murahabah and ijārah. To mitigate risks, Islamic banks use a variety of prudential reserves.

For example, trade-based contracts (murabaha, Salam and istisnaa) and leasing are exposed to both credit and market risks. For example, during the transaction period of a salam contract, the bank is exposed to credit risk and at the conclusion of the contract it is exposed to commodity price risk. However, the unique nature of Islamic financing, with a diverse set of instruments used as sources and uses of funds, calls for the development of new techniques, processes, institutional setup, and procedures to further improve risk management practices and challenge Islamic finance–specific risks.

Further standardization for Shari’ah compliance would benefit Islamic financial institutions. Unlike conventional banking where a unified set of international standards help agents to identify risks associated with the bank’s activities, Islamic financial institutions often face difficulties presenting internationally accepted Islamic instruments to their customers, while it seems challenging to standardize different interpretations of certain religious matters across jurisdictions and Shari’ah scholars.

For example, if a customer is interested in a new car costing Rs. 300,000 for a tenure of five years and is willing to pay a 50% security deposit, the monthly rental would be Rs. 300,000 × 0.014067 = Rs. 4220 per month for five years.

If a customer wants to buy a second hand car, is interested in a car costing Rs.300, 000 for tenure of five years and is willing to pay a 50% security deposit, the monthly rental can be calculated from Table 1.2. The monthly rental would be Rs. 300,000×0.014230 = Rs. 4261 per month for five years. Table 1.3 demonstrates the difference between a Car Ijara and a conventional car lease.

Table 1.1 Rental calculations for new cars

15 0.030399 0.024789 0.021590
20 0.028821 0.023533 0.020515
25 0.027242 0.022277 0.019440
20 0.025664 0.021021 0.018366
35 0.024085 0.019765 0.017291
30 0.022507 0.018508 0.016216
45 0.020929 0.017252 0.015142
40 0.019350 0.015996 0.014067

Security deposit (%)                           3 years                          4 years                                5 years

 

Table 1.2 Rental calculations for used cars

Security deposit (%) 3 years 4 years 5 years
20 0.029412 0.023940 0.020726
25 0.027799 0.022660 0.019639
30 0.026186 0.021379 0.018552
35 0.024572 0.020099 0.017465
40 0.022959 0.018819 0.016378
45 0.021346 0.017539 0.015290
50 0.019732 0.016259 0.014230
 

The Ijara contract is binding under the Sharia’a and does not contain any conditions that make the contract void.

  1. Conclusion

Islamic finance has expanded rapidly and is spreading across many regions. Islamic financial assets grew, on average, about 20 percent annually over the past decade. Despite this growth, Islamic finance still represents a very small share of global financial assets. To this end, several factors still constrain the realization of the full potential of Islamic finance. A few are discussed in this paper, such as lack of liquidity management instruments and underdevelopment of appropriate safety nets, notably Shari’ah-compliant deposit insurance scheme and lender of last resort facilities.

Islamic banks operating in many conventional systems do not have access to Shari’ah compliant tradable short-term treasury instruments to channel excess funds to other Islamic financial institutions. The absence of such instruments restricts growth, forces banks to hold excessive reserves, and also curtails the central bank’s ability to conduct monetary policy operations.

 

 

 

 

 

 

 

  1. Reference list

 

  • Krasicka and Nowak (2012) for more discussion on actions taken by Malaysia to ensure level playing field for the Islamic finance industry.
  • AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions (1999), Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks, Bahrain: AAOIFI.
  • The National Commercial Bank, Annual Report 2014.
  • Ahmad, Ausaf and Khan, Tariqullah (1997). Islamic Financial Instruments for Public Sector Resource Mobilization, Jeddah, Saudi Arabia: IDB, IRTI.
  • Ahmad, Ausaf and Khan, Tariqullah (eds) (1998). Islamic Financial Instruments for Public Sector Resource Mobilization, Jeddah, Saudi Arabia: IRTI.
  • Sole, Juan, 2007, “Introducing Islamic Banks into Conventional Banking Systems,” IMF Working Paper 07/175 (Washington: International Monetary Fund).
  • Abedifar, P., P. Molyneux, and A. Tarazi. 2013, “Risk in Islamic Banking.” Review of Finance, No. 6 Vol. 17, pp. 2035–2096.
  • Ahmad,Ausaf (1993),‘Contemporary practices of Islamic financing techniques’,research paper no.20,Islamic Research and Training Institute, Islamic Development Bank, Jeddah.
  1. Introduction

Shop around before you make a decision about buying or leasing. Consider the offers from different dealers and several sources of financing, including banks, credit unions, and finance companies. Comparison shopping is the best way to find both the vehicle and the finance or lease terms that best suit your needs as an example of our project today is a vehicle specifically Islamic Vehicle Financing.

This study will attempt to investigate tow big ideas; first what is the Islamic vehicle financing done with the Saudi Arabia Banks. To achieve the objectives of the study, we shall compare between the conventional finance and Islamic finance, especially on the process of vehicle finance on details. Second, we’ll move to the calculation part which is how Islamic banks in Saudi Arabia provide these services in their contracts to enhance the study.

1.1 The Vehicle financing

The vehicle financing is in direct lending, when get a loan directly from a bank. After the agreement to pay, over a period of time, the amount financed, plus a finance charge. Once enter into a contract with a dealership to buy a vehicle, you use the loan from the direct lender to pay for the vehicle. In Other hand, it is in dealership financing, which is another common type of vehicle financing, getting financing through the dealership, and a dealer, enter into a contract where you buy a vehicle and agree to pay, over a period of time, the amount financed plus a finance charge. The dealer may retain the contract, but typically sells it to a bank, finance company or credit union — called an assignee — that services the account and collects your payments.

Before we buy or lease a vehicle should be attention on these 3 points:

  1. Consider Federal and State Laws. b. Determine How Much You Can Afford. c. Monthly Spending Plan. Also, if we want to lease a vehicle must be considered the monthly payments on a lease usually are lower than monthly finance payments on the same vehicle because you are paying for the vehicle’s expected depreciation during the lease period, plus a rent charge, taxes, and fees. But at the end of a lease, you must return the vehicle unless the lease agreement lets you buy it and you agree to the purchase costs and terms.

However, to determine if leasing fits your situation:

  • Consider the beginning, middle and end of lease costs.
  • Compare different lease offers and terms, including mileage limits.
  • Consider how long you may want to keep the vehicle.

For instant:

Term 3 Years – 36 months 5 Years – 60 Months
Purchase Price $31,000 $31,000
Down Payment (20%) $6,200 $6,200
Amount Financed $24,800 $24,800
Contract Rate (APR) 5.00% 5.00%
Finance Charge $1,958 $3,280
Monthly Payment Amount $743 $468
Total of Payments $26,758 $28,080

 

  1. Difference between Islamic & Conventional Financing

The basic difference between Islamic Banking and conventional banking is the contractual relationship. This fundamental difference posed a totally different outlook on what happens after that. The contract between a customer and a conventional bank is simple; a loan where interest is charged upon. But look at an Islamic contract. The contract defines the relationship, the responsibilities, the subject matter, and the sequencing and ownership requirements for the use in an economic transaction. However, the transaction explains the rewards and returns on the completion of the contractual obligation by the regulators of the Shariah Committee; Cause and effect, risks and compensating return, action and rewards. The deployment of Islamic Banking funds is not for charity. It is still a business that should not charge interest. Moreover, the return on Shareholder capital is also important to ensure that capital is continued to be invested into Islamic Banking for it to grow. With growth comes the ability to continue supporting the ummah, the Muamalat defined within Shariah-compliant transactions. The main difference between Islamic Banking and conventional banking is that the concept of justice to customer is not regulatory driven; it is conceptually driven by the idea of Islamic Banking itself. A lot of conventional banking practices are developed to maximize returns while minimizing risk and risk-transference is a key consideration for conventional banks. Regulators have to be vigilant to ensure conventional banking to the line to protect customer’s interests.

  1. ISLAMIC VEHICLE FINANCING Vs CONVENTIONALVEHICLE FINANCING

With the increasing demands of everyday life, vehicle ownership has shifted from a mere luxury to a vital necessity. Purchasing a car is often the second most expensive, yet important purchase, after buying a home. While doing so, an individual has two options available: either to make a hand on hand (cash) purchase or to go for Vehicle financing. However, due to the exorbitant car prices and lack of the funds available, many individuals prefer the latter option and approach the various financial institutions, which provide this facility at different rates.

Vehicle Ijarah’ has been designed according to the principles of Islam and is completely interest-free. Moreover the Ijarah contract and other documentation also comply with Shariah requirements. On the other hand, a conventional car-financing scheme is actually an Interest based loan given by the financial institution and interest is charged on that loan. Also, in conventional car-leasing arrangements, the lease contract is not in compliance with Islamic Shariah and has Riba and other un-Islamic elements in it.

In ‘Car Ijarah’ the asset remains in the ownership and risk of the bank and the customers only pay the rentals for use of the asset; just like house rent. These basic differences are described in detail as the first term is (leasing or financing) that traditional systems provide financing for purchasing car, i.e. In essence, they are giving loan and earning interest. The Islamic car financing – It is not a financing scheme rather it is a lease contract. Ijarah is based on a lease contract. It is not a mixture contract. IJARAH is an Arabic term with origins in Islamic Fiqah, meaning to give something to rent. Leasing is a contract are transferred from the lessor, to another person is the lessee, at an agreed-upon price called the rent, and for an agreed-upon period of time called the term of the lease that is a second term (rental or installment).

Also, the term of (down payment or security deposit) that is in Ijarah the buyer is required to keep a security deposit at the bank. The minimum requirement for security deposit is 20% of the car value and the maximum is 50%. The requirement is different in the case of conventional car financing is a down payment made by the buyer of the car. The amount required for the down payment is 20% of the price plus the installment for the first year. Both the down payment and the security deposit mentioned above are one-time payments. However, the return in the Islamic mode of financing, the buyer has the right to return the car anytime during or at the end of the lease period, but in a conventional car financing the customer cannot return in any case.

  1. The Contracts used for Islamic Vehicle financing

-Murâbaḥah contract; the seller informs the buyer of his cost of acquiring or producing a specified product. The profit margin is then negotiated between them. The total cost is usually paid in installments.

-Ijārah (Lease, lease purchase); A party leases a particular product for a specific sum and a specific time period. In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.

Ijārah and murâbaḥah have many similarities and differences. In both financing modes, the bank is not a natural owner of the asset, but acquires it upon receiving a request from its client. Like murâbaḥah, ijārah rentals are paid in installments over time, and are supposed to cover the cost of the asset or the value of an investment for the bank and to provide a fair rate of return on investment. Thus, both contracts create debt. However, in murâbaḥah, the benefits and risks of ownership of the asset are transferred to the client along with ownership, ijārah rentals can be made flexible to reflect changing vehicle business conditions, especially if the rental period is very long. Murâbaḥah and ijārah are easily understood because of their close similarity to conventional financing (installment sales and leasing). Other contracts as Salam (Prepayment, deferred delivery) the buyer pays the seller the full negotiated price of a product that the seller promises to deliver on a future date.

-Istisna’ (Deferred payment, deferred delivery) A manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future. The price does not have to be paid in advance (in contrast to Salam). It may be paid in installments or part may be paid in advance with the balance to be paid later on, based on the preferences of the parties.

-Salam and istisna’ are less frequently used debt-based Islamic financing instruments that do not meet the condition of physical possession of the asset for sale; these are the only two exceptions to the principle that one cannot sell a commodity before it comes into existence.

There are four main differences between istisna’ and salam contracts. (i) istisna’ involves the sale of unique manufactured goods as opposed to salam that can be used in standardized goods. (ii) Unlike salam who requires the payment of the full price up front, istisna’ allows for spot, deferred, or even installment payments. (iii) An istisna’ contract can be cancelled unilaterally until the date that the manufacturer starts working on the goods, while the salam contract can be cancelled only before the contract signature. (iv) The time of delivery is fixed in salam, whereas istisna’ can specify a maximum time for delivery after which the purchaser is no longer bound to accept the vehicles.

  1. Islamic vehicle financing by Five Saudi Arabian banks and their products

— Al Rajahy Bank, Car Ijarah is simply a rental agreement under which the car is given to the customer on rent for a period agreed at the time of the contract. The customer is required to deposit an initial amount (security deposit) with the Bank. Upon completion of the lease period the customer has two options, either to return the car and take away the security deposit or take ownership of the car against his security deposit or any other agreed amount via separate sale transaction.

— Bank Al Riyad, Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.

— The National Commercial Bank (NCB), Murabaha is a Shariah-compliant form of financing where the Bank, based on requests from its customers, purchases specific commodities and sells them to the customers at an agreed-upon price equal to the Bank’s cost plus a specified profit margin, which is payable on a deferred basis in agreed-upon installments. The main uses of Murabaha are in residential, commercial real estate, and trade finance.

— Arabi N Bank, Istisna’a is a contract for the acquisition of assets to be manufactured in accordance with the specifications of the one who requests the assets to be manufactured / procured. In this product the Bank can either be the manufacturer/ procurer (Saani) or the party who is seeking the assets to be manufactured/procured (Mustasni). In project finance, the Bank takes the role of Mustasni and agrees with the customer to deliver specified assets for an agreed upon price. The Bank pays for the asset in staged payments. At the same time, the Bank enters into a forward Ijara and leases the assets to be created to the customer with promise to transfer ownership.  The main use of Istisna’a is in project finance combined with forward Ijara to finance the construction of new projects.

–Bank Al Balad, All the above Shariah-compliant financing products are accounted for in conformity with the accounting policies described in these financial statements. They are included in the financing and advances.

  1. Case Study

All banks apply the simple interest formula to calculate the total amount of the loan, then divide the total amount by the number of months. Example: Loan amount is 100000. The profit margin percentage rate is 2%. Number of financing years is 5. The total loan with profit margin is 100000* (1+2%*5) =110000. Monthly installments equals 110000/60=1833.33

Risk Management; in addition to facing common risks with conventional financial institutions, Islamic banks also face their own unique risks. The Shari’ah-compliant nature of assets and liabilities distinguishes them from conventional banks while at the same time exposing them to similar market, credit, liquidity, operational, and legal risks. Notably, differences in opinion among equity risk arise when Islamic banks enter into musharakah and mudârabah partnerships, as providers of funds and they share in the business risk of the activity being financed.  The mark-up risk tends to rank highly for Islamic banks. However, All in all, profit-sharing investment accounts (PSIA), diminishing musharakah, mudârabah, Salam, and istisna’ tend to be considered riskier than murahabah and ijārah. To mitigate risks, Islamic banks use a variety of prudential reserves.

For example, trade-based contracts (murabaha, Salam and istisnaa) and leasing are exposed to both credit and market risks. For example, during the transaction period of a salam contract, the bank is exposed to credit risk and at the conclusion of the contract it is exposed to commodity price risk. However, the unique nature of Islamic financing, with a diverse set of instruments used as sources and uses of funds, calls for the development of new techniques, processes, institutional setup, and procedures to further improve risk management practices and challenge Islamic finance–specific risks.

Further standardization for Shari’ah compliance would benefit Islamic financial institutions. Unlike conventional banking where a unified set of international standards help agents to identify risks associated with the bank’s activities, Islamic financial institutions often face difficulties presenting internationally accepted Islamic instruments to their customers, while it seems challenging to standardize different interpretations of certain religious matters across jurisdictions and Shari’ah scholars.

For example, if a customer is interested in a new car costing Rs. 300,000 for a tenure of five years and is willing to pay a 50% security deposit, the monthly rental would be Rs. 300,000 × 0.014067 = Rs. 4220 per month for five years.

If a customer wants to buy a second hand car, is interested in a car costing Rs.300, 000 for tenure of five years and is willing to pay a 50% security deposit, the monthly rental can be calculated from Table 1.2. The monthly rental would be Rs. 300,000×0.014230 = Rs. 4261 per month for five years. Table 1.3 demonstrates the difference between a Car Ijara and a conventional car lease.

Table 1.1 Rental calculations for new cars

15 0.030399 0.024789 0.021590
20 0.028821 0.023533 0.020515
25 0.027242 0.022277 0.019440
20 0.025664 0.021021 0.018366
35 0.024085 0.019765 0.017291
30 0.022507 0.018508 0.016216
45 0.020929 0.017252 0.015142
40 0.019350 0.015996 0.014067

Security deposit (%)                           3 years                          4 years                                5 years

 

Table 1.2 Rental calculations for used cars

Security deposit (%) 3 years 4 years 5 years
20 0.029412 0.023940 0.020726
25 0.027799 0.022660 0.019639
30 0.026186 0.021379 0.018552
35 0.024572 0.020099 0.017465
40 0.022959 0.018819 0.016378
45 0.021346 0.017539 0.015290
50 0.019732 0.016259 0.014230
 

The Ijara contract is binding under the Sharia’a and does not contain any conditions that make the contract void.

  1. Conclusion

Islamic finance has expanded rapidly and is spreading across many regions. Islamic financial assets grew, on average, about 20 percent annually over the past decade. Despite this growth, Islamic finance still represents a very small share of global financial assets. To this end, several factors still constrain the realization of the full potential of Islamic finance. A few are discussed in this paper, such as lack of liquidity management instruments and underdevelopment of appropriate safety nets, notably Shari’ah-compliant deposit insurance scheme and lender of last resort facilities.

Islamic banks operating in many conventional systems do not have access to Shari’ah compliant tradable short-term treasury instruments to channel excess funds to other Islamic financial institutions. The absence of such instruments restricts growth, forces banks to hold excessive reserves, and also curtails the central bank’s ability to conduct monetary policy operations.

  1. Reference list

 Krasicka and Nowak (2012) for more discussion on actions taken by Malaysia to ensure level playing field for the Islamic finance industry.

  • AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions (1999), Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks, Bahrain: AAOIFI.
  • The National Commercial Bank, Annual Report 2014.
  • Ahmad, Ausaf and Khan, Tariqullah (1997). Islamic Financial Instruments for Public Sector Resource Mobilization, Jeddah, Saudi Arabia: IDB, IRTI.
  • Ahmad, Ausaf and Khan, Tariqullah (eds) (1998). Islamic Financial Instruments for Public Sector Resource Mobilization, Jeddah, Saudi Arabia: IRTI.
  • Sole, Juan, 2007, “Introducing Islamic Banks into Conventional Banking Systems,” IMF Working Paper 07/175 (Washington: International Monetary Fund).
  • Abedifar, P., P. Molyneux, and A. Tarazi. 2013, “Risk in Islamic Banking.” Review of Finance, No. 6 Vol. 17, pp. 2035–2096.
  • Ahmad,Ausaf (1993),‘Contemporary practices of Islamic financing techniques’,research paper no.20,Islamic Research and Training Institute, Islamic Development Bank, Jeddah.

 

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Islamic Home Finaning – Case study based on KSA banks

by Maryam Hammad

1- Introduction:

 Most of people haven’t the financial affordability to build or purchase a house while only a few people own the resources that enable them to purchase their own house. So, they move towards the banks to request house mortgage for the long term repayment from their personal income.

 

2- What is home finance/mortgages?

 One of the most common forms of the debt is a home mortgage .Also, a home mortgage is one of the most advised. The consumer will has the lowest interest rate in a home mortgage loans than other type of debt.

 

 Home mortgages is a loan given by mortgage company , bank and other financial institution for residence purchasing or investment. The owner of the property ( borrower) transfers this property to the lender under the condition that the ownership of this property will be transferred back to the owner when the all payment has been made and after satisfying all terms and condition of home mortgage. 

 A home mortgage has fixed or floating interest rate and this rate is paid on monthly basis with a part of the amount of the loan principal. This interest will be decrease over time as paying down the principal by the owner.

 

3-Difference between Islamic finance and conventional finance:

·         Conventional Financing Principles

·         The essential part of the source of revenue in conventional institution is  the interest that charged on the money lending to the corporations and individuals. In addition, Interest is the main runner of conventional banks operations. Charging fee on international trade facilities, safety of wealth, guarantees and transfer of funds are other sources of income.

·         The Payment over a tenure  is made by installments in which  the part of  the payment of this installment goes towards servicing the interest and the remainder for down the principal.  Many facilities are provided by loan contract and it is known as a loan Facility agreement

·         Islamic Financing Principles

·         The system of Islamic finance operates according to the principle of Sharia and it promotes social justice.  Islamic finance concerns with moralities and values. so, immoral actions such as fraud, injustice gambling and ambiguity, are prohibited by Islam.  The transactions of interest-based (riba) are avoided by Islamic finance and it introduces the concept of buying something on the borrower’s behalf, and  then selling it back to the borrower at profit instead of interest-based transaction.  Profit and loss sharing in Islamic bank is based on Islamic mode of financing, Mudarabah and Musharka which is exclusive structured for Islamic institutions. Because Islamic institutions share the risk with the depositors, the risk in the Islamic institutions is lower than traditional institutions. 

 

4-Difference between Islamic home finance and conventional mortgages:

Conventional home financing is a common form around the world to purchase house where the customer signs a contract with the bank which contains schedule payment to be paid by the customer over specified period of time. The mortgage loans that provided by commercial banks offer this product for two groups of customer. The first is for commercial purpose and the second is for the residential purpose. The mortgage loan of commercial real estate is used for the purposes of business: building or purchasing shopping malls, restaurants and hotels and corporate offices while the residential loans are for general public usage to purchase or construct a house. 

Home financing according to Shariah-compliant is a financing a home form, in a way that the principles of Islamic law and its ruled do not violated. Also, the program of Islamic home financing does not involve  Riba (usury / interest), Maysir (gambling) and Gharar (speculation or contractual uncertainty).Generally, it is based on equity partnership between the bank and the customer  In Islamic home financing the customer pay monthly rent of the home purchased to the bank on the portion of funds supplied to purchase the home and this portion diminishes as the home purchaser pays to the bank to purchase the portion of the bank.  The wealth and income of conventional mortgage financing is not distributed equally and it create insecurity, stress and conflicts. In contrary, the shared equity financing which is in Islamic finance reduce the conflict, insecurity, and stress and make equitable society. 

 

5-Contracts used for Islamic home financing with process and details:

Islamic banks offer interest free products. The most common home financing products and structure are:

A- Murabaha or Bay’ Bithaman Ajil (BBA , deferred payment sale)

B- Diminishing Musharkah which is the most common product for home financing around the world

C- Parallel istisna (construction-required sale).

D- Ijarah (leasing).

 

A- Bay’ Bithaman Ajil Home Financing

 The Bay’ Bithaman Ajil ( commonly referred as ‘BBA”) home financing is based on deferred payment of shari’ah concept. It is a modification in the Murabaha (cost plus) contract, the product is received instantly while the price and the profit is paid in installments over long period of time.BBA term generally used in Malaysia and Brunei and it is known as bay mu’ajjal in the region of South Asia while in the middle eastern countries is known as bay murabaha. The facility of BBA is provided by Islamic bank to enable the home purchaser to pay the cost of financing. The bank purchases the assets  cash from vendor and sell is on credit basis to the customer. The selling price (The cost plus the profit) must be agreed upon concluding the contract between the customer and the bank. The bank is liable for liabilities and all defects until ownership is transferred to the customer.

The modus operandi of Bay’ Bithaman Ajil home financing:

1- The customer who want to purchase a house approach the bank for financing.

2- The bank  assesses the creditworthiness of the customer and approves the request.

3- The bank purchase the house from the developer and pay full amount on cash.

4- The bank sell the house to the customer at a markup price.

5- The customer pay the sales amount on an installment basis.

 

B- Diminishing Musharkah Home Financing 

 The diminishing Musharka (musharakah Mutanaqisa) is based on partnership equity. The customer and the bank (financer) create a contract to purchase a house jointly. The bank gives the option to the  customer (buyer) to purchase the portion of the bank in this house over the contract period. So, step by step the portion of the bank in this house will decline gradually till the end of the contract and the customer own the whole equity. This done by the customer who pays the schedule payment and monthly rent to buy the portion of the house that owned by bank. The rent that the customer pay is paid on the outstanding portion that owned by the bank. The contract can terminate at any point when the all remaining payment is paid by customer. 

The modus operandi of Diminishing Musharka home financing:

— 1- Musharaka contract is signed by both Islamic banks and customer in order to purchase the house. Jointly they will be the partners or owners of this house.  

— 2- At the beginning, the customer pay for example 20% as initial margin and the bank pay the remaining of 80%. 

— 3- The house will be rent to the customer after purchasing it, portion of the payment of the rent will go to the contract of Musharaka.

— 4- The ownership portion of the islamic bank will decline gradually from the payment of the rent.

— 5- The customer will have the full ownership of the house at the end of this contract.

C- Parallel Istisna Home Financing

 Istisna’ is an assets purchasing contract in which the purchaser place an order to purchase the assets that will deliver in the future according to the specification which is in contract. The purchase price, sale, and the installment will be decided by both parties. Parallel Istisna include two contract. The first contract is between the customer and the bank as a manufacturer, builder or supplier. The second contract between the bank as purchaser with a manufacturer, builder or supplier to meet the obligations of the first contract. The profit is realized from the difference of two contract.  

The modus operandi of Parallel Istisna Home Financing:

1- The customer request from the bank to construct a specified house (the specification include the type, nature, quantity, and the date of delivering). The price of the contract contain the cost to the bank plus the margin profit (e.g:250000). The customer will pay in deferred basis.

2- Islamic bank enter into another contract of parallel istisna’ contract with a subcontractor to develop the house (e.g;180000) as specified in the first istisna’ contract. The two istisna’ contract must remain independent .So, any problems arise of nonperformance of the one of the contracts should not  affect the other contract. 

3- The completed house will be delivered to the Islamic bank by the developer.

4- The Islamic bank will deliver the house to the customer and the installment must paid by the customer.  

D- Ijarah (leasing) Home Financing:

 Ijara is lease based contract used  by the Islamic banks under the principle of Ijara wa Iqtina,. The customer identifies a home and request the Islamic bank for financing. After analyzing the customer and the home by the bank, the bank purchases this  home and leases to the customer based on monthly schedule rent payment. Rizwanullah et al., (2012) argued that the customer contributes to the account to purchase the home  in addition of paying the rent. The bank will be responsible for all expenses that related  to this home. buyer equity of the home will increases with the payment. At the end of this contract the bank will transfer the  ownership of this home to the customer.

 

6- Islamic home financing instruments used by Saudi  banks ( example from Saudi Arabian banks and their products(:

Riyad Bank Islamic Home Financing :

 Riyad Bank provides financing of real estate host to its customers whose concern is to own a property. It provides to the customer all around the Kingdom of Saudi Arabia both a complete and incomplete property or a part of land and The mortgage advisors of Riyad Bank guide the customer to choose among this financing. The products of Riyad bank that based on islamic home financing are according to Shari’a compliant and are provided with competitive rates of profit margin and flexible payment plan. This products include:

·         Purchasing of Readymade Properties: Riyad Bank provides purchase of readymade property finance solutions and  providing the stability that its customers need. This product is provided with a high financing amount.

·         Purchasing Incomplete Property :Riyad Bank Home Financing assists the customer with purchase formalities and  it allows to pay regular installments based on the progress of construction with maximum finance amount.

·          Home Equity Readymade PropertyThe program of Riyad Bank’s Home Equity for readymade properties is offering to the customer with funds which support  in addressing the several needs of finance.

·         Home Equity Incomplete Property: Riyad Bank provides in this program for the customer the facility for making payments towards the completion of construction with financing up to SAR 5 million and terms of payment up to 240 month.

·         Land Finance: The Bank offers this product to support its customer to buy a land with various payment plans and maximum financing amount.

·         Subsidized Home Finance and Al-Moyassar Home Mortgage Programs: this is an innovative finance offered by Riyad Bank in cooperation with The programs of  Real Estate Development Fund and the Ministry of Housing in order to help the customer to own their dream house.

 

SABB Bank (The Saudi British Bank) Islamic Home Financing : 

 

·         SABB offers to its customer many options that enable them to own their dream house with the competitive rates of profit, high quality service for its customer and simple financing solutions. A wide range of products of Shariah compliant Home Finance are offered by SABB using:  The concept of Ijarah: SAAB buy property and leases this property to its customer. The financing period up to 25 years with a promise from the bank to transfer the ownership at the end of the period  to the customer. The lease rentals will be paid by the customer and the balance will be payable  to the bank over the period of financing in monthly installments. The properties that SAAB offers under the concept of Ijarah include: Completed villa, apartment or residential building, duplex, uncompleted house and land for building a home in future.

·         Istisna’a and Ijarah Mausoofa Fi-Dhimah: This is based on Construction + forward lease Structure concept and with the promise from the bank to  transfer the ownership to the customer at the end of the lease period. The period of flexible financing up to 25 years period , SAR 5 million financing amount and in which the bank is financing the customer who own the land to build his house. The value of the land will paid by the customer as a part of lease rentals in advance and the remaining balance is payable to SAAB over the period of financing in monthly installment basis. This product has quick approval and easy process.

The Saudi Investment Bank (SAIB) Islamic Home Financing

·          The Saudi investment bank is also provide Islamic home finance products.

·          ALASALAH Murabaha Home Finance: This is a product of an Islamic home financing that offered by the Saudi Investment Bank and this product is according to Shariah compliant and it is Murabaha based contract. The bank purchase the property based on the customer request and the process of evaluation. Then, the Saudi Investment Bank sells this property to the customer based on monthly payments for specified and a greed period of time. The time period can be from 5 years to 25 years with financing amount up to SAR 5 million.  At the end of the period and when the all installment are paid by the customer, the bank transfers the ownership of the property to the customer. Al ASALAH home finance is available for apartments, villas, land and the rate of profit is fixed over the financing period.

 

Al Rajhi Bnk Islamic Home Financing

Al Rajhi Bnk provides many solution for its customer who want to own a house, villa or apartment by purchasing or building. Also, it is providing opportunity to  purchasing a piece of land. Moreover, Al Rajhi Bnk helps the customer in purchasing an investment property and collecting the from the rent. The solutions that the bank provides based on Islamic home financing are:

·         Buy a home: this is for the customer who want to buy ready villa or apartment with finance period up to 20 or 30 years.

·         Buy a Land: this type for the customer who want to buy a land to build his house with finance period up to 20 years.

·         Real Estate Development Fund (REDF) additional finance: This is a program of  real estate financing that based on  the principle of Murabaha and it offers for the customer that satisfied the credit conditions of Al Rajhi Bank. The property  will be purchased  by Al Rajhi Bank on behalf of the customer based on full amount payment  to the seller on the basis that the development fund on behalf of the customer will pay an amount of 500 thousand Riyals towards the bank as an advance payment of the purchase amount. 

·         Home and More: here the bank provides in one package both home and personal at the same time.

·         National Commercial Bank (NCB) Islamic Home Financing: 

·         NCB provides Islamic home finance compatible with the provisions of sharia’ on the basis of Murabaha and Ijara. The bank require 30% down payment for this home finance  and the amount of finance up to 3 SAR million for payroll customers and 7 million for affluent customers with the possibility of early settlement and SAR 3000 is the minimum required  salary.

 

 

7- Case study – (Products, how do the bank calculates the rates and rentals, risk management, agreement, calculations based on Islamic bank):

In Al Rajhi Bank and under Islamic home financing the bank provides services of Home and More in which the bank provides in one package both home and personal at the same time. In the case of monthly salary is SR 10,000  the customer can get the following finances a according to Al Rajhi Bank terms and condition:

 

Personal  Home

Finance Amount (SR) 183,468 Finance Amount (SR)

888,451

Term Cost % 3.50% * Finance Rate % 2.95% *

Annual Percentage Rate (APR) % 4.01% * Effective Rate % 5.05% *

Finance Period (Years) 5 Finance Period (Years)

Total Monthly Installment (SR) 6,000

Number of Installments ( Months) 240

* source: Al Rajhi Bank.

 

·         Parallel Istsina’ home financing case study of one of  Malaysia Islamic bank:

·         The customer identifies a house to purchase and approach the bank for  financing. Then, the customer and the bank will agrees on financing using alistisna’. The bank will enter on parallel al-istisna’ contract with housing  developer to deliver the house as specified in the first istisna’ contract for say SAR 500,000 and now the bank is the owner of this house. After that , the customer will pays as agreed payment schedule over the period of  al-istisna’.

·         For Example; If the purchase price of  the house is SAR 600,000, profit rate is 10% and the customer down payment is 10% (SAR 60000). A financing tenure is 30 years and the installment will be paid on monthly basis. The bank enter parallel istisna’ with the developer which cost 530000 .The computation is as below;

– Annual installments = i((1+i)^n)PV/((1+i)^n)-1

 

= .10 ((1+.10)^30)(600000-60000)/ ((1+.10)^30)-1

 

=SAR 52,282.87

 

– Monthly installments= Annual installments/12 months

 

= 52,282.8/12 

 

= SAR 4,356.90 per month

 

=4,356.90 x 30 years x 12 months

 

= SAR 1,568,486.10

 

   So, the total payment is SAR 1,568,486.10 and SAR 4,356.90 is the monthly payment for the period of 30 years.

 

The risk management of Parallel Istsina’ home financing

 

– Credit risk Management:  1- the probability of  the expected loses and default are assessed carefully by the bank. 

 

2- Generally , band al-Jazaa ( penalty clause) frequently used by bank to ensure that the manufacturer are produce or construct as specification in the contract.

 

3- The delivery of the fund can be agreed on the different phases of the construction. So, the payments will be aligned with milestones.

 

– Market risk Management:

1- The property or the commodity is sold before the date of delivery through parallel Istisna’. by bank.

2-Basid on the different scenarios of market the future market price will be valued.  

3- VAR analysis was used to the market risk management and to the future market price evaluation.

– Liquidity risk Management:

1- Several quantitative models are used by the bank to identify the risk and the price of its product will determine according to that risk.

– Operational risk Management: 

1- The bank ensure that there was not any misappropriation in the distributed fund by ensure that the payment to the supplier with the inspection and ensure the property take place.

2- Ensure that appropriate quality is followed by the manufacturer by taken guarantees from the manufacture.

   

8- Conclusion:

 The system of Islamic finance operates according to the principle of sharia and it is promote social justice. Also, Islamic finance concerns with moralities and values. Islamic bank offer  for its customer many options that enable them to own their dream house with the competitive rates of profit, high quality service for its customer and simple financing solutions. A wide range of products of Shariah compliant Home finance are offered by several Islamic bank.

 Islamic home financing products is more beneficial for the customer than conventional home financing. Also, because Islamic institutions share the risk with the depositors, the risk in the Islamic institutions is lower than traditional institutions.

 

9-  References:

 1. 10 Common Guidance Residential Islamic Home Financing Questions. (n.d.). Retrieved May 08, 2017, from https://www.guidanceresidential.com/blog/10common-guidance-residential-islamic-home-financing-questions/

2. Al ASALAH Murabaha Home Finance. (n.d.). Retrieved May 08, 2017, from https://www.saib.com.sa/en/content/al-asalah-murabaha-home-finance

3. Alrajhibank. (n.d.). Retrieved May 08, 2017, from http://www.alrajhibank.com.sa/en/personal/home-finance/pages/default.aspx

4. Asian Institute of Finance. (2013). Risk Management In Islamic Banks

5. Staff, I. (2017, March 07). Home Mortgage. Retrieved May 08, 2017, from http://www.investopedia.com/terms/h/home-mortgage.asp

6. Home Finance. (n.d.). Retrieved May 08, 2017, from http://www.sabb.com/en/financing/home-finance/

7. Home Financing. (2017, March 07). Retrieved May 08, 2017, from http://www.myuif.com/financing/shariah-compliant-home-financing/

8. Home Loans – Best Housing Loan & Finance. (n.d.). Retrieved May 08, 2017, from https://www.riyadbank.com/en/personal-banking/homeloan?gclid=Cj0KEQjw6LXIBRCUqIjXmdKBxZUBEiQA_f50PhWHyANzD 9Vr7bhrTN-poBL8jYYUzQkh7kKg5VuFc4UaArZB8P8HAQ&gclsrc=aw.ds

9. Ibrahim, M., & Kamarudin, R. (2014). THE ISLAMIC HOME FINANCING IN MALAYSIA ISTISNA’ BASE ON DEBT: QUALITATIVE APPROACH. Labuan e-Journal of Muamalat and Society,,8.

10. L. (2016, May 23). Islamic vs Conventional Financing. Retrieved May 08, 2017, from https://loanstreet.com.my/learning-centre/islamic-vs-conventionalfinancing

11. {{meta.title}}. (n.d.). Retrieved May 08, 2017, from https://www.souqalmal.com/sa-en/home-loans/ncb-home-finance

Diploma in Islamic Finance Course 2017

The following list of courses were prepared from the relevant institutions website. Please contact the institutions for further detail. islamic finance courses-1

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Islamic Credit Cards – An Introduction

Authors

  • Silwan Qurabn (MIFM Graduate Student, Effat University, KSA)
  • Mona Alansari (MIFM Graduate Student, Effat University, KSA)

 

Introduction

1) A Credit card is a revolving credit facility within the credit limit and credit period is determined by the issuer of the card. It is also a mean of payment.

2) The holder of the credit card is able to pay for purchases of goods and services and to withdraw cash, within the approve credit limit determined by the card issuer bank.

At the very start of 20th century people used to pay cash for all the goods and services they buy, In 1920, Oil companies and department stores started offering courtesy cards which were metal charge plates, which holder can use to make purchase but such cards were mainly accepted only by the merchant who has issued them, such card were more like the modern days store cards.

There is famous story of McNamara’s dinner at Major’s Cabin Grill New York restaurant, next to the Empire State building, when McNamara finished his Dinner with his friends and reached into his pocket to pay money for meal and shocked when discovered that he forgot his wallet home, immediately called his wife to bring wallet and he paid bill with embarrassment, but from that Dinner he came up with new idea of credit cards which can be used at multiple locations. Mc Namara and his lunch friends Bloomingdale and Sneider all three pooled money together and created a new credit card company in 50’s named it as Diners Club.

At the very beginning Diners club credit card were given to 200 people mainly the friends, such card were initially accepted only on 14 new York restaurants and such cards were not made up of plastic instead of paper and accepted merchants were printed on the back of paper, just in second year profit was more than $60,000.

Diner’s club card first started as mass acceptance, which enabled the cardholder to spend more than no cardholders, and diners club charged 7% fee on each transaction, which also required holder to payback all amount at the end of each month. Just after one year it has 42,000 members and by 1953 it was the first internationally accepted charge card company, within just 40 years its position was challenged by the other major competing companies such as American Express which first issued the plastic card.

Among the other the most innovative one was bankAmericard started from California, and spread, it was most accepted in California, in later years Interbank card association emerged to smooth the transaction between merchant, bank and cardholder, BankAmericard eventually became Visa, while the inter bank card association letter became MasterCard. Both card got acceptance almost everywhere and later on issuer’s starts adding perks to attract more customers, the entry of discover card further enhanced competition. Up till late 1960 there were no concrete regulation in credit card industry although millions of people were now using this facility, and because of lack of regulation different issuers were charging much different interest rate and there were number of frauds in practices, the first major legal and regulation process started with “The Truth in lending Act and consumer credit protection act, with such acts standardize method of calculating interest introduced. More regulation were added for the consumer protection through the consumer credit protection act. After the 2008 financial crisis, more regulation were added in “the truth in lending act” through the card act of 2009.

 

How Does Credit Cards Work In Conventional Banking?

Conventional credit card system evolved after the Diners Club inc, and American Express. Under the conventional credit card banking system, merchants account is credited by the bank and money is immediately paid to the merchant, while charges are assembled to the credit card holder at the end of billing period, which the credit card holder pays to bank either entirely or in installment with the interest rate also called as Carrying charges.

Credit card is a financial product which is issued by your bank or other financial institution which allows you to make purchase and take cash advance. The main difference between the charge card and credit card is that charge card required you to make full balance payment at the end of month, which credit card allows you to carry balance indefinitely as long as you can make minimum payment at the end of each month.

Credit cards let you to spend money on credit, you can spend up to a limit which is preset when the card is issued, Once you use the credit card, you are required to make a minimum payment every month before the due date and if you are unable and failed to make that minimum payment, then the interest charges will be applied usually charges are applied to backdated when the goods or services is purchased. The best way to avoid any extra charges and using card wisely is to make sure that you are able to make monthly payment, and we can avoid any fiancé charges if we can make full payment back before the 30 days or end of month.

In normal credit card transaction there are three parties involve, 1) card issuer, 2) payment network 3) merchant. Whereas card issuer is your bank, payment network are normally widely accepted, Visa or MasterCard , normally logo are marked on our credit cards, and merchant is the place from where we make purchase, normally merchant has specially bank called acquiring bank which handle the transactions.

For example you finished your dinner in a bank, and swipe your card in a little machine to pay your bill, that machine transfer your information to merchant (Restaurant’s bank), merchant bank use the Visa or Mastercard payment network, receive authorization from the card issuer bank, once card issuer bank accept the transaction it transfer funds to network (Visa, MasterCard) which then sends funds to your restaurant’s or merchant bank’s account. Later on you pay the balance wither as whole or as in monthly installments.

 

How Does Credit Cards Are Structured In Islamic Baking?

In terms of functions and definition, the Islamic Credit Cards are same like the conventional credit cards, the only thing that is avoided and prohibited is Usury or interest rate, and Islamic credit cards are compliant with Shariah and Islamic principle especially regarding the payment of credit cards.

According to Islamic laws, hadiths and Quran, it is prohibited to pay interest on the money which is withdrawn in advance, like this all the additional interest charges of delaying payment is also prohibited, but if credit card are only served as charge card where you pay the principle amount plus the services charges then its allowed and permitted.

Tawarruq, Murabaha, Bay al Inah and Ujrah are widely used in recent Islamic banking, whereas Bal Al Inah means selling goods with immediate purchase, and Ujrah means service charges or charges against the rendering service.

Bay Al Inah involves selling and buy back transaction of assets by the seller, where seller sales asset to buyer at cash and then buy back on deferred payment basis at higher price,  so Bay al Inah is a two parties contract where a person sells commodity on credit at specific price, and then buy back at lesser price for cash, and the difference between that specified price and lesser price is called profit, modern Islamic banking refer that profit as the credit limits.

Islamic credit card are used and allowed only to buy halal goods and services, Islamic credit card cannot be used to purchase anything that is declared haram by the Shariah. The main different between the Islamic credit cards and conventional credit cards are Riba (interest) and Gharar (Overcharging) both are prohibited in Islamic.

Another famous financial instrument concept used in Islamic credit cards is Tawarruq, where the buyer buys a commodity from seller on deferred payment basis, and the sells same commodity to another party at cash or on the spot payment basis. Basically in this way initially buyer is borrowing cash from the bank via initially purchase, like this way in Islamic credit card use customer buy goods or services from bank on cost plus profit basis and then customer resale it on cash basis, so Tawarruq is basically transfer of ownership process and allowed by the shariah.

Ujrah is another concept used in Islamic credit, it’s the fee that Islamic banks charged against the services they render to its customers, so Ujrah is service fee.

 

Islamic Credit Cards Used In KSA

In Saudi Arabia, AlAhli Islamic Credit Card use the Taqarruq as a financial Instrument for making credit transaction, according to this concept as mentioned above customer buys the good or service from Islamic bank at a marked up price to be paid latter then quickly sales the goods for cash, but it is also necessary tangible assets should underlie all the transaction, for example buying a precious metal from bank at $1000 and then selling it to market at $900 cash.

SABB another bank in Saudi Arabia uses Tawarruq (Mal) and Murabah (SAHM) financial instrument for credit lending, where you can get credit up to SAR 1,500,000 with 5 years of repayment period, but the card holder mush be above 21 years and should have minimum salary above SAR 3000.

According to Tawarruq contact you buy a metal from SABB bank at higher price (bank keeps its profit) on deferred payment, and sale it into market for cash at lower price.

According to Murabaha concept SABB bank purchase Shariah compliant share from local stock market and sale you at known fix profit, after buying share from SABB bank you have the option either to invest share in halal investment portfolio or Sale share to generate cash.

Saudi Investment bank is another Islamic bank which issue Silver, Gold and platinum credit cards to its customers, SAIB and SAMBA credit card also works on Tawarruq principle basis as we discuss earlier.

AL Rajhi credit card works on Murahaha finance basis and offers customer flexibility where you buy now and pay later.  Here bank purchase goods such as car, furniture, electronics or any other goods on behalf of customer and then sell it to customer at a profit, and intermediary retain the ownership of the goods until the loan is fully paid.

 

Case Study – An Islamic Credit Of A Bank

United Arab Bank UAE

United Arab Bank in UAE functions on the basis of personal Murabaha Finance solutions which is a contract between the bank and its client, where bank purchase the goods and sell them to client at cost plus profit on deferred payment basis, and client is required to make payment to bank on installment basis, in this way bank can avoid the charging interest rate forbidden in Islam.

An example of Murabah finance is owning a car, for example you have a favorite car and you want to buy it but you don’t have money to pay it off at once, under United Arab bank Vehicle murabaha scheme bank will purchase the car for you can sell it to you at purchase price plus profit margin, and you will pay back money in installment, the benefit of this credit is that you know the profit and total amount which you have to pay to the bank.

 

MayBank Malaysia

Maybank is based in Malaysia and their credit card products are variety of Visa and MasterCards under the name of MAybankIkhwan.

The concept if MayBank Islamic credit card is based on the Bay Al Inah and Ujrah,  Bay al inah is buy back contract , where seller sale goods on credit at higher price and buy back on cash bases at lower price, different between two prices is profit and it’s also the credit limit.

But the problem with such method is that, buying and selling is pre-specified with no risk, which is haram in Islam, plus most of the cases this is only on the paper buy and sale and no actual physical asset is moved.

Because of the above mentioned problems bank also uses the Ujrah as financial instrument, which is basically charges for rendering services.

Like the conventional bank MayBank also has grace period of 20 days. And Maybank Islamic card requires 5% of the outstanding loan as the minimum payment. In case of failure to make minimum payment 1% of the outstanding loan is charges as a fee and then used to help needy people to perform Umrah trip.

References

Tsosie, Claire. “The History Of The Credit Card – Nerdwallet“. NerdWallet. N.p., 2017. Web. 26 Apr. 2017.

“The Incredible True Story Of The Very First Credit Card”. ThoughtCo. N.p., 2017. Web. 26 Apr. 2017.

ZAID, FATIMAH. “The Difference Between Conventional And Islamic Credit Card”. Academia.edu. N.p., 2017. Web. 1 May 2017.

Erol, C., Kaynak, E. and Radi, E.B., 1990. Conventional and Islamic banks: patronage behaviour of Jordanian customers. International Journal of Bank Marketing8(4), pp.25-35.

Jamshidi, D. and Hussin, N., 2012. A conceptual framework for adoption of Islamic Credit Card in Malaysia. Kuwait Chapter of the Arabian Journal of Business and Management Review2(3), p.102.

http://www.alahli.com/en-US/personal-banking/credit-cards/Documents/Credit-Card-terms-EN.pdf

http://www.sabb.com/en/financing/personal-finance/

https://www.saib.com.sa/en/content/visa

http://alrajhibank.com.sa/en/personal/credit-cards/cards/pages/platinum-visa-credit-card.aspx

https://www.samba.com/en/pdf/Samba_Alkair_TC_en.pdf

https://www.usbank.com/credit-cards/how-credit-cards-work.html

https://www.uab.ae/islamic-banking/murabaha

https://www.moneyadviceservice.org.uk/en/articles/credit-cards

http://www.quickanddirtytips.com/money-finance/credit/how-do-credit-cards-really-work

https://www.capitalone.com/credit-cards/blog/how-credit-cards-work/

http://www.maybank2u.com.my/

http://www.maybank2u.com.my/mbb_info/m2u/public/personalDetail04.do?channelId=CRD-Cards&cntTypeId=0&cntKey=CRD01.34&programId=CRD01-CreditCards&chCatId=/mbb/Personal/CRD-Cards