Murabaha: Definition, Example, and Financing Under Islamic Law

What Is Murabaha?

Murabaha is an Islamic financing structure in which the seller and buyer agree to the cost and markup of an asset. It's also referred to as cost-plus financing.

The markup takes the place of interest, which is illegal in Islamic law. Murabaha isn't an interest-bearing loan or qardh ribawi. It's an acceptable form of credit sale under Islamic law. The purchaser doesn't become the true owner until the loan is fully paid, as with a rent-to-own arrangement.

Understanding Murabaha

A client in a murabaha contract of sale petitions a bank to purchase an item on their behalf. The bank establishes a contract setting the cost and profit for the item with repayment typically in installments. A set fee is charged rather than riba or interest so this type of loan is legal in Islamic countries.

Islamic banks are prohibited from charging interest on loans according to the religious tenet that money is only a medium of exchange and has no inherent value. Banks must therefore charge a flat fee for continuing daily operations. 

Many argue that this is simply another method of charging interest but the difference lies in the structure of the contract. The bank buys an asset and then sells it back to the client with a profit charge in a murabaha contract for sale. This type of transaction is halal or valid, according to Islamic Sharia/Sharīʿah.

Murabaha and Default

Additional charges may not be imposed after a murabaha due date and this makes murabaha default an increasing concern for Islamic banks. Many banks believe that defaulters should be blacklisted and not allowed future loans from any Islamic bank as a method of decreasing murabaha default.

This arrangement is permissible in Sharia even if it's not expressly mentioned in the loan agreement. Respite may be given as described in the Quran if a debtor is facing a genuine hardship and can't repay a loan on time. The government can take action in cases of willful default, however. Defaults under murabaha arrangements 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 typically used in place of loans in diverse sectors. Consumers use murabaha when purchasing household appliances, cars, or real estate. Businesses use this type of financing when purchasing machinery, equipment, or raw materials. Murabaha is also commonly used in short-term trade such as issuing letters of credit for importers.

A murabaha letter of credit is issued on behalf of an applicant or 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. The bank’s creditworthiness replaces that of the applicant so the beneficiary or exporter is guaranteed payment. This benefits the exporter because the bank assumes the payment risk.

The importer is required to repay the bank for the cost of goods plus a profit markup amount following the murabaha contract provisions.

Example of Murabaha

Bilal would like to buy a boat that sells for $100,000 from X Boat Shop. Bilal would contact a murabaha bank to do so. The bank would buy the boat from X Boat Shop for $100,000 and sell it to Bilal for $109,000 to be paid in installments over three years.

The amount Bilal pays is a fixed amount to a bank that owns the asset. There's no interest charge involved. Bilal would not incur additional charges for default on any payments. The additional amount Bilal pays over the cost price from the boat shop is in effect a 3% loan but it's allowed by Islamic law because it's offered as a fixed payment without any additional costs.

The Bottom Line

Interest-bearing loans are prohibited under Islam’s Sharia law but this doesn’t mean that Islamic consumers don't ever need financing. Murabaha financing is used instead. This type of financing doesn’t charge interest but a markup is built into repayment. The consumer doesn’t own the product until the loan is fully paid, as with interest-bearing financing.

Islamic law provides that money has no real value in and of itself so banks charge a flat, extra fee for extending loans instead.