Islamic banking comprises of a series of financial products that have been developed to allow Muslims to invest and raise finance in a manner that does not undermine their religious beliefs. This is because one of the main principles of Islamic finance is that earning interest, or riba, is forbidden, therefore banks cannot directly lend a customer money.
With all Islamic transactions, an underlying asset is key to ensure the transaction is valid – therefore banks have developed structures that allow a customer to sign up for personal finance that is sharia-compliant.
Murabaha – The bank purchases goods on behalf of a customer
One example of this is Murabaha. Here, a bank will purchase goods on behalf of a customer – such as a new car, furniture, electronics or a home – and then sell them to the customer at a profit. The profit, added to the customer’s monthly installments, is referred to as a profit rate. It is very similar in structure to a “rent to own” arrangement as the intermediary retains ownership of the goods or property until the loan is paid in full.
Tawarruq – Is commodity Murabaha
Another concept often used in the UAE Islamic banking industry is Tawarruq. This is a development of Murabaha and is sometimes referred to as commodity Murabaha or reverse Murabaha as it involves having access to cash through the trading of a commodity in a real transaction.
There are two main steps involved in Tawarruq; first is the Murabaha stage where the bank and the customer enter into a commodity Murabaha contract – this could be where a bank buys shares or commodities on behalf of the customer and then leases them back to the customer. The customer then owns – either physically or constructively – the assets subject of the Murabaha contract. The second step in this process is the asset liquidation stage – where customers can choose to either sell or liquidate the assets via an agency agreement through the bank.
Which one is used, when?
Generally, Tawarruq is permitted for those transactions that cannot be fulfilled through other Islamic Banking means such as giving a customer access to cash for the financing of intangible personal needs. These can include short-term needs such as travel, education or renovating a home – or just to give a customer some cash to resolve a cash flow crisis. Murabaha, on the other hand, is generally used for longer-term loans such as the purchase of a house or car.
However, it can be confusing for customers as to which personal finance product falls under which concept. Traditionally, Tawarruq was a transaction that involved three parties (the bank, the customer and the broker) and Murabaha involved four (the bank, the customer, broker one and broker two). But these terms have merged as scholars requested that most three party-transactions be enhanced to four – making the difference between the two very blurred. Among many scholars today, the terms are virtually interchangeable.
Read more of our guides: Islamic Banking – how does it work? | Islamic bank accounts explained | Islamic credit cards explained | Islamic personal finance explained | Islamic car finance explained | Islamic home finance explained. We also have a guide to Islamic finance for SMEs.