Islamic banking is a financial system operating according to Islamic Sharia principles, prohibiting Riba (interest), Gharar (excessive uncertainty), and Maysir (gambling). In this comprehensive guide, we explain the most important Islamic finance products, how they work, and which one suits your needs.
Principles of Islamic Banking
Islamic banking is built on several fundamental principles:
- Prohibition of Riba: Charging or receiving interest on money is forbidden
- Prohibition of Gharar: Transactions must be clear and transparent
- Profit and Loss Sharing: Parties share risks and returns
- Asset-backed: Every financial transaction must be linked to a real asset or economic activity
- Ethical Investment: Financing prohibited activities is not allowed
Murabaha (Cost-Plus Financing)
Murabaha is the most widely used Islamic finance product. In this contract:
- The client asks the bank to purchase a specific item (car, property, goods)
- The bank buys the item from the seller at the original price
- The bank sells the item to the client at a higher price that includes a known, agreed-upon profit margin
- The client pays in predetermined monthly installments
Mudaraba (Profit-Sharing Partnership)
Mudaraba is a partnership contract between two parties:
- Rab al-Mal (Capital Provider): Provides the capital (usually the bank or investor)
- Mudarib (Entrepreneur): Provides labor, expertise, and management
Both parties share profits according to a pre-agreed ratio, while financial losses are borne solely by the capital provider (unless the mudarib was negligent). Mudaraba is used in savings accounts, investment deposits, and Islamic investment funds.
Musharakah (Joint Venture)
Musharakah is a contract where two or more parties contribute capital and work together:
- All partners contribute capital
- Profit is divided according to agreement (not necessarily proportional to capital)
- Loss is distributed according to capital contribution ratio
A special type called Diminishing Musharakah is widely used in real estate financing, where the bank and client purchase the property together, and the client gradually buys out the bank's share.
Ijara (Islamic Leasing)
Ijara is an Islamic leasing contract:
- The bank purchases the asset (car, equipment, property)
- Leases it to the client for specified rental payments
- At the end of the contract, ownership can transfer to the client (Ijara wa Iqtina)
Tawarruq (Commodity Murabaha)
Tawarruq is used to obtain cash liquidity. The client buys a commodity from the bank on credit, then sells it to a third party for cash at a lower price. It is widely used in personal financing but remains debated among scholars.
How to Choose the Right Product?
- Buying a car or property: Murabaha or Ijara wa Iqtina
- Getting cash liquidity: Tawarruq
- Investing: Mudaraba or Musharakah
- Saving: Mudaraba accounts or Wakala bil Istithmar