Murabaha — Cost-Plus Financing

Murabaha is the most widely used instrument in Islamic banking, accounting for a significant majority of Islamic financial transactions globally. In its basic form, murabaha is a sale in which the seller discloses the cost of the item and adds a known profit margin. In Islamic banking, the bank acts as an intermediary purchaser: the client identifies what they need (a car, a house, equipment), the bank purchases it and then sells it to the client at cost plus an agreed markup, with payment typically in installments.

How It Works

The process has several steps. First, the client approaches the bank and identifies the asset they wish to acquire. Second, the client and bank agree on the terms: the bank's purchase price, the markup amount, and the repayment schedule. Third, the bank purchases the asset from the supplier, taking actual ownership and bearing the risk during this period. Fourth, the bank sells the asset to the client at the agreed markup price. Fifth, the client pays in installments over the agreed period. The key Shariah requirement is that the bank must actually own the asset, even briefly, and bear the risk of ownership before selling it to the client.

Conditions for Validity

For murabaha to be valid under the Shariah, several conditions must be met. The underlying asset must be halal. The cost and markup must both be clearly disclosed to the buyer (unlike conventional lending, where the total interest is not always transparent). The bank must take actual possession of the asset before selling it (constructive possession, where the risk transfers, is sufficient according to most scholars). The sale must involve a real asset, not money for money. Late payment penalties, if applied, must be donated to charity and not kept by the bank as profit. Some scholars allow a small administrative fee for late payment but prohibit any amount that resembles interest.

Criticism and Response

Murabaha is sometimes criticized as being similar to interest-based financing in practical outcome. Critics point out that the installment payments resemble loan repayments with interest, and the markup effectively functions like a fixed interest rate. Islamic scholars respond that the structural differences are significant: in murabaha, the bank takes real ownership risk; the profit is from a sale transaction (which is halal) rather than a loan (which generates riba); the price is fixed at the time of sale and cannot increase for late payment; and the transaction is tied to a real asset. The Quran itself distinguishes between sale and riba: "Allah has permitted trade and has forbidden interest" (Quran 2:275). Nevertheless, many scholars encourage banks to develop more equity-based products (musharakah, mudarabah) that better embody the spirit of Islamic finance.

Modern Applications

Murabaha is used for home financing (the bank buys the house and sells it to the client), vehicle financing, equipment financing for businesses, commodity financing (tawarruq, which is more controversial), and trade financing. In home financing, murabaha is often combined with diminishing musharakah, where the bank and client co-own the property and the client gradually buys out the bank's share. This hybrid structure more closely aligns with the profit-and-loss-sharing ideal of Islamic finance while providing the predictability that both banks and clients prefer.