July 21, 2024
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Understanding Islamic Car Financing: A Comprehensive Explanation

Islamic finance is a growing subsector of the UK’s wider financial services industry. The UK’s significant Muslim population, with just under four million Muslims, drives the demand for Sharia-compliant products in all areas of banking and finance.

Fintech companies have been instrumental in this growth, disrupting traditional financial institutions by offering services tailored to specific demographics.

This trend is also noticeable in the UK’s car finance sector, where there is an increasing need for car finance options that align with Islamic principles.

Islamic car finance mainly consists of two products: murabaha and ijara wa iqtina. Understanding these principles is crucial for grasping the differences between Islamic car finance and conventional options.

Murabaha

In a murabaha transaction, which translates to profit in Arabic, the fundamental concept is the buying and selling of an asset. For example, if a customer seeks financing for a £30,000 vehicle from an Islamic bank, the bank would purchase the car for £30,000, add a profit margin (e.g. £10,000), and sell it to the customer for £40,000. The ownership of the car immediately transfers to the customer, who then makes payments to the bank over an agreed period, such as five years. The key feature of murabaha is that the bank’s profit is fixed, regardless of the customer’s repayment timing.

Ijara wa Iqtina

Also known as ijara muntahia bittamleek (rent ending in ownership), ijara wa iqtina is structured as a rental agreement. In this scenario, the bank would purchase the vehicle for £30,000 and retain ownership, renting it to the customer for a specified period (e.g. five years). After the rental period ends, ownership of the vehicle transfers to the customer. This option offers more flexibility, as if the customer pays off the vehicle sooner, the bank earns less.

Applying Islamic principles to car finance

Islamic finance is guided by principles outlined in the Qur’an. One key verse, Surah Al-Baqarah, Ayah 275, states: “… they say, ‘Trade is [just] like interest.’ But Allah has permitted trade and has forbidden interest.” While trade and interest may seem similar mathematically, they are fundamentally different in Islamic finance. Here are some key distinguishing factors:

1. Intrinsic value of money

In Islam, money itself does not inherently hold value; it is merely a medium of exchange for goods and services. A transaction in Islamic finance must involve an underlying asset or service, unlike conventional interest-based loans where money generates more money.

2. Real Economy ties

Islamic finance is closely tied to the real economy, with each transaction linked to an actual asset or service. This approach avoids the speculative nature of many conventional financial products and proved beneficial for Islamic banks during the global financial crisis.

3. Ethical financing

Islamic finance prohibits investments in sectors deemed harmful, such as alcohol, gambling, and tobacco. This ethical stance ensures that the financing contributes to overall societal well-being.

4. Penalty-free difficulty

In Islamic finance, institutions do not profit from customers’ financial difficulties. If a customer experiences payment delays without valid reasons, the bank may request a charitable donation, approved by the Shariah board, instead of retaining the amount as income.

5. Structured process

Islamic financing follows a structured process. For instance, in ijara wa iqtina, agreements are signed in a specific order: first a request for ijara, then the bank purchases the vehicle, followed by the ijara agreement, and finally, the sale and purchase agreement post-rental period.

6. Risk & reward

Risk and reward are distributed differently in Islamic finance. In murabaha, the bank bears ownership risk for a short period, whereas in ijara wa iqtina, the bank retains ownership risks, and the customer is responsible for the vehicle’s usage. If a insured vehicle is damaged before pickup, the bank bears the loss, not the customer.

Looking ahead

Islamic car finance is a recent addition to the UK’s financial market. However, with the expanding Muslim population and the growing demand for ethical finance, it is poised to gain a larger market share. Awareness and comprehension of Islamic car finance principles will further accelerate its adoption, setting it apart from conventional financial products. As the sector progresses, it is likely to offer more customized solutions to meet the varied needs of UK consumers.

Abdullo Kurbanov is CEO and co-founder of Ayan Capital

Halal car finance: driving diversity and choice in the UK vehicle financing sector


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