What is the Murabaha?
Murabaha, also called extra cost financing, is an Islamic financing structure in which the seller and the buyer agree on the cost and mark-up of an asset. The markup takes place of interest, which is illegal in Islamic law. As such, the murabaha is not an interest loan (qardh ribawi) but an acceptable form of sale on credit under Islamic law. As with a rent sale arrangement, the acquirer does not become the beneficial owner until the loan has been fully repaid.
Key points to remember
- Interest-bearing loans are prohibited under Islamic Sharia law.
- In Islamic finance, murabaha finance is used instead of loans.
- Murabaha is also referred to as cost-plus financing because it includes a mark-up on the profits in the transaction rather than interest.
- A seller and a buyer agree on the cost and mark-up, which is then paid in installments.
Understanding the Murabaha
In a murabaha sales contract, a customer asks a bank to purchase an item on their behalf. In accordance with the customer’s request, the bank establishes a contract fixing the cost and benefit of the item, with repayment usually in installments. Because a fixed fee is charged rather than riba (interest), this type of loan is legal in Islamic countries. Islamic banks are prohibited from charging interest on loans according to the religious principle that money is only a medium of exchange and has no intrinsic value; banks therefore have to charge a fixed fee for the continuation of day-to-day operations.
Many argue that this is just another method of charging interest. However, the difference lies in the structure of the contract. In a murabaha sales contract, the bank buys an asset and then sells it back to the customer with a charge on profits. This type of transaction is halal or valid, according to Islamic Sharia / Sharia law.
The issuance of conventional loans and the collection of interest thereon are considered to be interest-based activities, which are haram (prohibited) under Islamic Sharia law.
Murabaha and default
Additional fees cannot be imposed after a murabaha expiration date, making the default of the murabaha a growing concern for Islamic banks. Many banks believe that defaults should be blacklisted and should not be allowed to obtain future loans from any islamic bank as a method of reducing murabaha defect. Although not expressly mentioned in the loan agreement, this arrangement is permitted in Sharia law. If a debtor is facing genuine hardship and cannot repay a loan on time, respite can be given as described in the Quran. However, the government can take action in the event of a voluntary default. Failures under the murabaha agreements have become a problem for companies operating under Islamic law and there has been no clear consensus on how to deal with them.
Use of Murabaha
The murabaha form of financing is generally used instead of loans in various sectors. For example, consumers use the murabaha when purchasing household appliances, cars, or real estate. Companies use this type of financing when purchasing machinery, equipment or raw materials. Murabaha is also commonly used for short-term trading, such as issuing letters of credit for importers.
A murabaha letter of credit is issued in the name of an applicant (importer). The bank issuing the letter of credit undertakes to pay a sum of money in accordance with the conditions described in the letter of credit. Because the bank solvency replaces that of the applicant, the beneficiary (exporter) is guaranteed payment. This benefits the exporter because the bank assumes the payment risk. In accordance with the terms of the murabaha contract, the importer is required to reimburse the bank for the cost of the goods plus an amount of profit margin.
Example of Murabaha
Bilal would like to buy a boat that sells for $ 100,000 from Billy’s Boat Shop. To do this, Bilal would contact a murabaha bank, which would buy the boat from Billy’s Boat Shop for $ 100,000 and sell it to Bilal for $ 109,000, to be paid in installments over a three-year period. The amount Bilal pays is a fixed amount to a bank that owns the asset and there is no interest payable. In addition, if Bilal defaults on a payment, he will not incur any additional costs. The additional amount Bilal pays over the cost price of the boat store is actually a 3% loan, but since it is offered as a fixed payment at no additional cost, it is permitted by Islamic law.