What is 'Murabaha'

Murabaha, also referred to as cost-plus financing, is an Islamic financing structure in which the seller provides the cost and profit margin of a commodity.  Murabaha is not an interest-bearing loan (qardh ribawi) but is an acceptable form of credit sale under Islamic law. Similar in structure to a rent-to-own arrangement, the purchaser does not become the true owner until the loan is fully paid.

BREAKING DOWN 'Murabaha'

In a murabaha contract of sale, the client petitions the bank to purchase an item for him/her. Complying with the client's request, the bank establishes a contract setting the cost and profit for the item, with repayment typically in installments.  Because a set 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 Islamic tenet that money is only a medium of exchange and has no inherent value; so banks must charge a flat fee for continuing daily operations. 

Many argue that this is simply another method of charging interest.  However, the difference lies with the structure of the contract.  In a murabaha contract for sale, the bank sells an asset and charges profit, which according to Islamic Sharīʿah/Sharia is hala or valid.  Issuing conventional loans and charging interest are interest-based activities, which are haram (prohibited) according to Islamic Sharīʿah.

Requirements for Murabaha

For meeting Islamic standards of a legal sale, murabaha is completed in two stages. In the first stage, the bank purchases a commodity that the client is selling. In the second stage, the client agrees to a payment schedule for repurchasing the good. Because murabaha involves two transactions, two sale contracts are used.

Murabaha and Default

Because additional charges may not be imposed after a due date, murabaha default is an increasing concern for Islamic banks. Many banks believe defaulters should be blacklisted and not allowed future loans from any Islamic bank as a method of decreasing murabaha default. Even if it is not expressly mentioned in the loan agreement, this arrangement is permissible in Shariah, the body of Islamic law. Therefore, if a debtor is facing a genuine hardship and cannot repay a loan on time, respite may be given as described in the Quran. However, the government may take action in cases of willful default.

Examples of Murabaha

The murabaha form of financing is typically used for fulfilling Islamic loan requirements in diverse sectors. For example, consumers use murabaha when purchasing household appliances, cars, or real estate. Businesses use this type of financing when purchasing machinery, equipment, or raw materials. However, murabaha is most commonly used for short-term trade, such as issuing letters of credit for importers.

A murabaha letter of credit is issued for a beneficiary (exporter) on behalf of an applicant (importer). The bank issuing the letter of credit agrees to pay an amount of money in compliance with the terms described in the letter of credit. Because the bank’s creditworthiness replaces that of the applicant, the beneficiary is guaranteed payment. This benefits the exporter because the bank assumes the payment risk.

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