Islamic banking has gained popularity in recent years and its share of the total banking industry is up to 13% in Pakistan. Some argue that Islamic banking has more stability and resilience than traditional banking, while for others it may simply provide a sense of peace of mind, knowing that they are Shariah compliant in another aspect of their lives. Islamic banks are largely competing with traditional banks as far as their target market and products are concerned, which is why auto finance is one of their key product offerings in Pakistan.
I mentioned in my earlier article that the economics of conventional and Islamic auto finance are largely similar, with a few key differences in deal structure. The main difference is in the ownership of the vehicle. Within Islamic auto finance, there are two sub-categories of how banks may structure the deal – Ijarah (leasing) and Musharakah (partnership).
Under Ijarah, the bank is the sole owner of the vehicle on purchase and charges rent to the consumer for the duration of the lease. The lease can be structured in a way that the customer may acquire the vehicle automatically at the end of the lease, or have a lower monthly payment and have an option to purchase the vehicle with a balloon payment at the end. This is similar to the Residual Value model under conventional auto finance. This is an option, so you may opt to return the vehicle once the lease period is over. Depending on the condition of the car and affordability of the balloon payment, it may be beneficial to you to buy the car at this stage, especially if the lease term was short (i.e. 4 years or below).
Musharakah means partnership or joint ownership. Under such an agreement, the bank takes up part ownership of the vehicle at the time of purchase. For example, if you put up a 30% down payment, the bank would own 70%. According to the Musharakah agreement, the bank’s share of the vehicle is split into ‘units of ownership’ and the client undertakes to purchasing the bank’s units periodically. These units are priced on the length of the agreement and the amount invested by the bank plus its profit rate. The purpose is for the client to purchase complete ownership of the vehicle over the specified term of the agreement. So, your monthly payments to the bank comprise of a rental element and an ownership element. The rental aspect of the payment diminishes over time with the bank’s stake in the asset, similar to how your interest diminishes as you pay back your principal under a traditional loan.
There are two important fundamentals of the transaction under the above methods as opposed to conventional banking. Firstly, it is asset-based. This means the bank is lending an asset, the vehicle, which has intrinsic value and not money which does not. Secondly, the bank bears all or some of the risk of loss to the asset beyond your control and negligence, depending on Ijarah or Musharakah. For example, if the vehicle is stolen or destroyed by natural disaster, a conventional bank would continue to charge lease payments as normal until the settlement of the insurance claim (remember, insurance is compulsory!), whereas Islamic banks claim not to charge any rentals during such a period since the asset is not in use. Since the bank takes on risk, it justifies sharing the reward of the transaction in the form of profit.
Islamic profit rates are similar to conventional interest rates and are usually linked to KIBOR as well, however the aforementioned contractual fundamentals form its claims to being Shariah compliant. The benefit to the consumer is the ability to use the vehicle as they please, and the benefit to the bank is profit. After all, Islamic banking is a business and not a charity.
Islamic banks apply the concepts of Ijarah and Musharakah to other long term assets such as homes as well. Generally, Musharakah is used for higher value, longer term assets such as homes or factory machinery. Some banks like BankIslami and Faysal Bank use the Diminishing Musharakah model for auto financing, whereas others such as Meezan and Al Baraka use the Ijarah model, which is somewhat more common for vehicles.
Other differences in Islamic auto finance include conditions around late payments. Conventional banks would charge a late payment penalty, whereas Islamic banks are not allowed to do so as that would be considered Riba. Customers are usually asked to donate a certain amount to charity instead. Islamic banks normally incorporate Takaful (Islamic insurance) as part of the monthly rentals whereas conventional banks offer conventional auto insurance to go with the car, which may have to be paid up front. Islamic banks also claim to have lower up front processing fees for their products, although this may vary from bank to bank.
Much ado about nothing?
The argument against Islamic finance says that it is no different than the status quo. At the end of the day, If I borrow Rs. 100,000 at a 10% annual interest rate from a traditional bank, or have an Islamic bank invest Rs. 100,000 at the same rate in the asset, I would still have to repay Rs. 110,000 after a year in both cases. Isn’t Islamic finance just the same thing with different names? Some may even argue that owning a vehicle provides its own sense of pleasure, made possible with some conventional auto loans. Islamic banks claim that they do not charge rent on any period in which the vehicle is out of use due to circumstances beyond your control such as theft, but do they actually follow this practice? In reality, such a situation may present its own obstacles and red tape. Unfortunately, I do not have first-hand experience of this so I cannot be certain.
Ultimately, it is a matter of personal opinion, beliefs and principles. The effect of both conventional and Islamic auto finance on your bank account will almost be exactly the same. There is no doubt however, that there are key differences in the contractual relationships. The question is whether these relationships make a difference to your life. Does following the Ijarah model and paying rent and profit as opposed to ‘interest’ provide you peace of mind? Or are you a pure capitalist at heart and don’t really care what the relationship is called? Is being Shariah compliant important to you? If it is, then it is equally important to understand how the product or service you are buying is compliant, and verifying its claims independently. Do your research and make an educated decision as to what kind of product fits into your way of life.