Sale based financing has always been a main point of argument between the Bank and Customers. The single matter of “Selling Price” which is a requirements of all Sale-based financing such as Bai-Inah, Murabaha, Istisna’, Commodity Murabaha and Bai Bithaman Ajil, has resulted in many disputes especially in the scenarios of Early Settlement. At any point of time, the Customer will see the outstanding Selling Price of their financing, and as the Selling Price is imbued with the profit to be earned for the financing, this figure is always seen as “expensive” for the Customer.

For example a financing of RM100,000 with a 8.0% p.a. financing rate for 3 years. The monthly instalments, whether a conventional financing or Islamic financing, will be RM3,133-64. This calculation is the same for all banking. The main contention is the fixing of the selling price, which is a mere basic formula of RM3,133-64 x 36 months (3 years) = RM112,810-92. Essentially this is the same amount a conventional loan will eventually collect. A grand total of RM112,810-92. The only difference is that under conventional banking, that amount of RM112,810-92 is not fixed as a ceiling, so technically, the customer may end up paying more than that should the base lending rate increases. There is no issue of Islamic financing is more expensive because of this. The maximum amount on the financing that a Bank can collect is RM112,810-92.

But what some customers see is different. For example, for a conventional loan, if the customer wants to early settle on the 12th month, the customer is required to pay off the principal amount outstanding i.e. RM69,286-41. For an inquiry on Islamic product for the same period, the Bank usually informs customer on the outstanding Selling Price (RM75,207-28), which includes the unearned profits(RM5,920-87) for the financing. Of course, for early settlement, we will usually grant discretionary rebate on the Selling Price, which effectively wipes out the unearned profit amounts. What the customer eventually will pay will be exactly the same as what a conventional loan will indicate i.e. Outstanding Selling Price (RM75,207-28) less Unearned Profit (RM5,920-87) = RM69,286-41. With proper understanding of the Islamic product mechanics, you will find Islamic products nowadays are at par with the conventional loans structure.

**The requirement to provide Schedule of Payment**

Whether justifiable or not, the perception when it comes to calculations for Islamic Banking products, it is felt to be too complicated to understand. Under this new guidelines, the above calculation is now needed to be made clear and transparent. The purpose is to improve understanding of the structure.

Customers must therefore be provided with a schedule of payment, with clear illustration that at any point of time the customer can have an indication of what is the “rebate” (the unearned profit still yet to be earned), provided that the customer follow the schedule of payment (monthly instalments). This is also in line with the requirement that the Banks are now required to provide mandatory “Ibra” under the following scenarios i.e:

- Early Settlement – whenever the customer intends to make a lump sum early settlement, the unearned portion must be waived as a rebate.
- Refinancing – same scenario as Early Settlement, where rebate is on the “unearned profit”
- Restructuring – if the restructuring resulted in the reduction of tenure, the “unearned profit” for the shortened tenure
- Default Settlement – this refers to the point where during settlement (default cases) i.e. the default judgment amount is actually settled by the customers. The Ibra is only given once the amount is settled (provided that there is remaining “unearned profit” not earned yet).

By issuing a “schedule of payment”, the Bank commits the amount of rebate in such instances where rebate is mandatory, and provides a basis of “equal” comparison between an Islamic structure and a conventional loan.

As a matter of clarity on the above, it is also prudent to make distinction to the types of Ibra’ that can be given, into two types:

- Ibra (rebate) arising from the above scenarios i.e. early settlement, refinancing, restructuring, and default settlement, and/or
- Ibra (rebate) arising from the discount given for the difference between the maximum selling price and the price calculated against a benchmark, which is incurred based on certain events. For example, a sale price based on a profit rate of 9% but the seller agrees to provide a discount of 3% on the sale price based on certain scenarios e.g. good payment record, or low funding cost (Base Financing Rate). Therefore the customer (buyer) is paying profit for 6% where he enjoys the rebate of 3%.

The guideline on Ibra’ therefore only applicable for the above item 1, as item 2 is generally still deemed as discretionary (instead of mandatory) in the eyes of the Islamic industry.

Overall, the requirement for the Schedule of Payment is a good step to increase transparency and a useful tool to explain to customer the workings of Islamic Banking product. This guidelines goes a long way to dispel the notion that Islamic products are inherently more expensive than conventional products. The requirement that Bank MUST give Ibra’ for early settlements provide a lot of comfort to the customers and with the Schedule, customers can see exactly where they financially stand at any point of time. It is a good Guideline issued by BNM.

**Ibra’ Scenario for Recovery**

One of the things to remember is that during recovery stage of a default account (within financing tenure), Ibra’ is to be given only on settlement. Therefore, the Letter of Demand (LOD) issued will be based on “Outstanding Sale Price” and a disclaimer that “Ibra’ will be given upon full settlement” of the default financing. For example, the Sale Price Outstanding is RM200,000 (where outstanding principal with earned profit is RM120,000 and unearned profit amount is RM80,000) therefore the LOD must be based on RM200,000. But once the customer able to make full settlement, the Ibra must be given starting from the base amount of RM80,o00 i.e. outstanding unearned profit.

Ibra’ on the Differential Pricing

The guidelines very clearly outlines the different scenarios where Ibra is given for settlements. However, it is very silent when it comes to the Ibra’ arising from the differential pricing of the floating rate structure between the contracted ceiling rate and the effective profit rate. For example, the contracted ceiling rate = 12% p.a. and the effective profit rate = 8% p.a. The customer will only be charged 8% and the differential amount of 12% less 8% = 4% p.a. This 4% constitute a natural Ibra arising from the floating rate mechanism. I presume, this Ibra is not part of this guidelines.

very useful information. tq

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Dear Amir,

I read with great interest your article on Islamic Financing, especially the Ibra.

I have a lingering doubt and I hope you could shed some light.

You’ve mentioned on restructuring of the loan as one of the scenario. Let’s refer to your amortization table above, RM100,000 with a 8.0% p.a. financing rate for 3 years. Let’s assume on the 13th month, I pay my monthly installment and also additional prepayment of eg: RM 20,614.68 towards sale price (principal). The bank will then restructure my loan from the 14th month onwards, The outstanding purchase price from 14th month onwards shall be RM 66,614.68-RM 20,614.68 = RM 40,000. What would be the outstanding sale price after the principal payment of RM 40000?

How do we calculate this?

It is my assumption that in Islamic banking, the selling price is fixed in all circumstances (correct me if I’m wrong). In above scenario, if I made prepayments towards principal, my tenure will get shorter and I do think that the total amount that I’ll be paying eventually in this shortened tenure is far lesser than the selling price (due to unearned Ibra). So, in this sense, the selling price seem to be not fixed but instead reduces when there is reduction in outstanding principal. Is my understanding correct or flawed? It is very confusing. I wish you could kindly explain, with numbers, if your time permits.

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Hi Vijay

In general, the Sale Price in the system works basically as follows:

1) The Sale Price is the sum of all the installment. It is a fixed amount for the purpose of formalising the Aqad.

2) The Sale Price reduces based on the amount paid. If installment is paid, the Sale Price reduces by the Installment amount paid.

3) In situations where the amount paid is more than the scheduled installments, the excess amount reduces the principal amount resulting in a lower principal outstanding for the next month.

4) The profit for the following month is based on the lower principal outstanding. This results in the following month’s profit being lower thus the principal paid portion being accelerated if the installment remains the same amount.

5) The net result is that the principal gets paid off faster i.e. tenure is shortened.

To your question, what is then the outstanding Sale Price when additional principal is paid?

You are right on the principal amount i.e. the Outstanding Principal is RM66,614.68 less RM20,614.68 = RM46,000 (slight error on your calculation of RM40,000 above)

As for the Selling Price, the system merely records the full amount as the reduction to the Selling Price.On the 14th month, the Outstanding Selling Price is RM72,073.64. If you made payment totalling RM23,748.32 (ie RM3,133.64 installment + RM20,614.68 additional principal payment), the “new” Selling Price will be RM72,073.64 less RM23,748.32 = RM48,325.32

Therefore at month 14th:

Outstanding Principal = RM46,000.00 (instead of RM63,925.14)

Outstanding Sale Price = RM48,325.32 (instead of RM68,940.00)

I understand your question as you will say that there is another element in the Sale Price where it should be adjusted for i.e. the rebate on unearned profit for the additional principal paid i.e. rebate of the unearned profit for RM20,614.68. It really depends on the system we use; some system are developed to immediately calculated this rebate and deduct further from the Outstanding Sale Price. This will be most accurate.

But many systems are not able to do this and the first impression is that this will result in unfairness to the customer if this portion of profit is not deducted.

The beauty of the Ibra guidelines essentially implies that Ibra must be given and you can only take income which you deserve. Any undeserved profit, due to early settlement or principal payment, must not be taken by the bank. Therefore as long as the principal amount is correctly reflected in the system (which will result in the “right” amount of profit charged subsequently) the Sale Price outstanding remains valid as the above formula.

What will happen is that when the principal outstanding amount eventually = 0, the unearned profit = outstanding Sale Price amount will be “rebate”, i.e. the Sale Price is zerorised as the facility is deemed paid off. The unearned profit portion will be the only amount left outstanding at the end of the “accelerated tenure” and therefore will be written off as rebate (as there is no more principal left and thus any further profit is unjustifiable)

Hope that answers your question.

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Hi Amir,

I digged into BNM’s Ibra document recently. In that document, a formula for settlement amount was given.

Settlement amount = Outstanding selling price +Instalments due + Late payment charges – Adjustments on Ibra due to fluctuations of EPR (if any) – Ibra at settlement.

While I understood all the components above, only “Adjustments on Ibra due to fluctuations of EPR” is something which I couldn’t understand.

Is there a formula to calculate it? The same document states that:

” Ibra due to fluctuations of EPR is equivalent to the difference between profits based on EPR & CPR”

Could you kindly illustrate this with some calculation example?

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Hi Vijay, that’s a good observation. There is 2 types of Ibra implied by the Ibra guidelines ie one is the daily/monthly/yearly Ibra arising from the difference between the contracted profit rate (CPR) and the effective profit rate (EPR), and the second Ibra arises during early settlement where the future “unearned” income is waived to be collected from the customer as Ibra.

I will write a post on this topic soon with some illustration inshaAllah, if I manage to find that time to sit and write.

Thanks Vijay

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Hi, Based on your amortization table provided above, I wanted to ask one question.

as you can refer to column “Profit payment” and “principle payment on purchase price”, the total of these 2 column is equivalent to “Installment (monthly)”…

May I know, how the portion for these TWO column been calculated for every month for Islamic financing?

for example, please refer to month 13 row…the monthly installment RM3,133.64 is consist of RM 461.91 (Profit payment) and 2671.73 (principle payment on purchase price)…why not the ratio be RM 400 (Profit payment) and RM 2,733.64 (principle payment on purchase price) or else?

need your explanation, thank you.

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Salam Ridhwan

The calculation is based on monthly reducing balance where the month’s profit is calculated by the monthly profit rate multiplied against the principal balance outstanding. This is a standard calculation for monthly principal reducing balances. However, there are no prohibition to change the methodology of profit calculation if all parties agree to the method which is informed clearly prior to entering the contract. It all remains on which calculation formula is acceptable by the parties.

Hope that helps.

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As salam, just want to find out, how you get the profit portion of 12,810.92 as based on my calculation : 100,000 x 8% x 3 years = 24,000. Thank you.

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Hi Redhawi,

The calculation is based on the annuity calculation (monthly reducing balance) used by most banks for mortgage calculation.

The calculation you mentioned as RM100,000 x 8% x 3years is based on the flat rate calculation used generally by the hire purchase products ie profit is not based on reducing principle but flat throughout the years. 8% p.a. flat rate is around 14% to 15% monthly reducing rates.

Hope that explains it.

Thanks

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Hello Brother, do you think, is there any unethical issues in ibra?

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Salam Mahmudul Haque, my personal opinion it doesn’t raise any unethical issue if applied correctly. The intention is to bring it on par with conventional banking, but that implies that the practices of conventional banking is acceptable by Shariah all the time. If the practice is to bring it to par to an unacceptable practice, then it is not right. The application must match the right practice, fairly and justly.

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Assalamualaikum sir, may i know you reference?

it is from BNM or AAOIFI?

thank you

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Salam

Generally I am focusing in BNM guidelines for my writings, not so much reference on AAOIFI standards. My writing is now mostly focusing on Malaysia’s perspective, not so much on middle-east as I have left my job in the middle-east in 2011.

Thanks

Amir

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