Pricing an Islamic automobile financing using Rule of 78 — perspective

RULE OF 78 has been employed in Islamic automobile financing products to distribute profit charges across to the duration of the financing. Rule of 78 has some particular characteristics but are not confined to:

Firstly, the maximum amount of profit is paid at the start of the financing. In other words, profit earned by Islamic banks is of greater at the beginning of the repayment.

Secondly, the term Rule of 78 comes from 12 months of a oneyear period. 12 months are added up together that is 1+2+3+4+5+ 6+7+8+9+10+11+12 to get a sum of 78.

Thirdly, early repayment is made up of profit instead of principal. At the beginning, profit’s portion repaid is in particular higher but gradually decreases when the customer keeps on servicing his monthly instalment.

To understand, two particular formulas are used.

The first formula is the sum of the digits (SOD) and the second one is the profit earned by an Islamic bank. The former is based on this formula: n * (n+1) / 2 whilst the latter is obtained as [(Total no of month — no of month paid)+1]/ Sum of the digits x total profit payable].

In our contemporary banking industry, Rule of 78 has been applied to al ijarah thumma al bay (AITAB) and murabahah to the purchase orderer (MPO) automobile financing contracts. Following this rule, the determination of monthly instalment, selling price and profit to the bank can be computed and, somehow, it is easily computed using Microsoft Excel.

Rule of 78 is extendable to Islamic automobile financing provided these five considerations are met:

Firstly, the amortisation table that is crafted by the banker should be conveyed to the customer, communicated obviously and made accessible to the customer¡¦s knowledge or alternatively needs to be made available virtually on the bank respective URL.

Secondly, the terms and conditions drawn from the pricing must be both agreed by the transacting parties to uphold the transparency.

Thirdly, Islamic banks should communicate to their customers in that the banks impose ta’widh that is not considered as a penalty but instead of a compensation or an actual loss to the bank. In contrast, however, gharamah is what has been found in conventional car loans. Fourthly, the bank must communicate to the customer that the early settlement can be made possible but the customer will need to pay more profit to the bank.

Fifthly, Islamic automobile financing products are based on financing and leasing and they are not that of loan, which leads to a sale and lease-based transaction.

Likewise, the problem of Rule of 78 for Islamic automobile financing products is when one intends to make an early settlement of the financing.

The bank basically spreads the cost of profit higher at the beginning of the financing that means the bank maximises the profit when the customer decides an early financing resettlement.

Thus, the customer who expects to save money by clearing off the financing earlier would actually be incurring some losses as a result of this rule. Rule of 78 may also raise a riba al-jahiliyyah (i.e. conventional automobile loan) when the penalty is charged at the expense of ta’widh and there is an element of compounding interest that is quite burdensome.

This issue is not occur in Islamic automobile financing products as each bank has been monitored by a well-versed Shariah committee.

For an illustration, assume that Hulk is unable to pay monthly instalments from July to August in 2019 (two months).

The interest in the conventional car loan can be of: JULY (1) 1,000*8%*31/365=RM6.795, AUGUST (2) 2,006.795*8%*31/365 =RM13.64. If he intends to settle them on 1st September 2019, he needs to pay a sum of RM2,000 + RM13.64 + RM6.795 = RM2,020.43.

The addition of RM20.43 is riba al-jahiliyyah. It is compounded.

Comparing apples to apples, the amount of ta’widh to be paid by Hulk who opts for Islamic automobile financing in the case he is not capable to pay the monthly instalment from July to August in 2019 (two months), the amount of compensation is therefore: JULY (1) 1,000*1%*31/365=RM0.849, AUGUST (2) 2,000*1%*31/365=RM1.699. If he intends to settle them on 1st September 2019, he needs to pay a sum of RM2,000 + RM0.849 + RM1.699 = RM2,002.55. The sum of RM2.55 is known as a compensation charge. It is, however, not compounded.

To be Islamic, at least three rules are strictly followed: Islamicity 1: Rebate is given when the customer performs a full settlement and it is incorporated in the financing agreement to eliminate uncertainty with respect to the customer¡¦s entitlement to earn rebate from the bank.

At the discretion of the bank (if possible), extra rebate may be allowed for accelerating the settlement that is done on a case-by-case basis. Islamicity 2: Payment holiday is given for a genuine reason for the postponement, the bank can think about in extending the facility¡¦s repayment duration.

Time extension and restructuring in repayment are of two recommendations that can generate a positive impact to many.

Islamicity 3: There exists a clarity in all documents that made between the bank and the customer, beginning the offer letter and the agreement documents. All parties must agree on terms and conditions, which are associated with Rule of 78.

If the customer intends to take up the facility until the end of the repayment duration, then Rule of 78 is the best but if he is not, perhaps, a simple rate method or flat rate is of the best option to be taken up.

The customer should make an improved reading culture to be aware of the two pricing mechanisms in helping them to make a sound decision pertinent to an automobile financing. Rule of 78 is somewhat popular among Islamic banks than that of a simple rate method.

Besides a cogent assistance by the banker, the customer should be self-regulating and proficient in selecting the best option of Islamic automobile financing products. Consequently, a right decision is made to improve his financial wellness.

It is now timely to consider a socalled “Customer-Based Islamic Banker” in which the customer becomes a banker on his own in making a sound decision for patronages.

Besides, this may help to build up a pool of believers that can establish “Islamic Banking - Conscious Society” via an inculcation of Islamisation of Financial Transactions and for that our nation’s blueprint to attain 40% market share of Islamic financing in 2020 can be achievable, may Allah (SWT) bless us. Yet, this warrants an empirical investigation to claim its validity and appropriateness to the current context, at least.