What Is Murabaha?

What Is Murabaha?

Let me explain Murabaha directly: it's an Islamic financing approach known as cost-plus financing, where a bank transfers ownership of an asset to you after you make payments that include a profit markup.

This system sidesteps interest charges, which are forbidden under Islamic law, by treating the deal as a sale rather than a loan. The bank purchases the asset and sells it to you, with payments in installments that cover the bank's profit.

Murabaha qualifies as an acceptable lending method under Islamic principles. You don't fully own the asset until you've paid everything off, similar to a rent-to-own setup.

Understanding Murabaha

In a Murabaha contract, you approach a bank to buy an item on your behalf. The bank sets up a contract with the cost and profit, and you repay in installments. Instead of interest or riba, they charge a fixed fee, keeping it legal in Islamic countries.

Islamic banks can't charge interest because money is seen as just a medium of exchange with no inherent value. They charge a flat fee to cover operations.

Some say this is just interest in disguise, but the contract structure differs: the bank buys the asset and sells it back to you with a profit. This makes it halal under Sharia.

Murabaha and Default

You can't add extra charges after a Murabaha due date, which heightens default risks for Islamic banks. Many banks suggest blacklisting defaulters to prevent future loans from any Islamic institution.

This is allowed under Sharia, even if not in the agreement. If you're in real hardship, respite might be granted as per the Quran. For willful defaults, governments can intervene. Defaults remain a challenge without a clear consensus on handling them.

Use of Murabaha

Murabaha replaces traditional loans in various sectors. You might use it for buying appliances, cars, or real estate. Businesses apply it for machinery, equipment, or raw materials. It's also common in short-term trade, like letters of credit for importers.

In a Murabaha letter of credit, the bank pays on your behalf as an importer, guaranteeing payment to the exporter by assuming the risk. You then repay the bank the cost plus a markup per the contract.

Example of Murabaha

Suppose you want a boat costing $100,000 from a shop. You contact a Murabaha bank, which buys it for $100,000 and sells it to you for $109,000, payable over three years.

Your payments are fixed to the bank that owns the asset, with no interest. No extra fees for defaults. The markup acts like a 3% loan but is permitted under Islamic law as a fixed payment without added costs.

Related Concepts

Rent-to-own agreements in the US let you lease a property with an option to buy later, setting aside part of rent for a down payment—similar to Murabaha in structure.

Countries like Bahrain, Malaysia, Indonesia, Saudi Arabia, Bangladesh, and Pakistan use Murabaha, with over 65% of wholesale Islamic banks in Bahrain relying on it in 2022.

Willful default means intentionally failing to meet contract terms, knowing it's wrong, unlike negligent defaults.

The Bottom Line

Sharia prohibits interest-bearing loans, but Islamic consumers still need financing. Murabaha provides it with a markup instead of interest. You don't own the product until fully paid, like in interest-based systems.

Under Islamic law, money has no intrinsic value, so banks add a flat fee for loans.