Islamic finance contracts: murabaha, ijara, musharaka, mudaraba

Why Islamic banks use contracts instead of loans

A conventional bank lends money and charges interest. Islamic finance treats interest on a loan as riba, which is prohibited (see Riba explained). It also avoids excessive uncertainty and gambling (see Gharar and maysir).

Islamic banks therefore structure financing as trade, leasing or partnership. Each structure is a named contract from classical Islamic commercial law. The bank's return comes from a sale margin, a rent or a share of profit, not from interest on money lent.

The main reference points are:

• AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions). Its Shariah Standards cover murabaha, ijarah, musharakah, mudarabah and many other contracts. Many regulators and Shariah boards use them.
• The International Islamic Fiqh Academy of the OIC. It issues resolutions on specific questions, such as promises in murabaha.
• National bodies in Pakistan: the State Bank of Pakistan's Shariah Board, the Council of Islamic Ideology and the Federal Shariat Court, which has ruled on riba in the banking system.
• Each bank's own Shariah board, which approves its products.

We do not issue rulings. This page describes the contracts and the positions of recognised bodies and scholars. For a personal question, ask a qualified scholar or mufti you trust. The broader background is in Islamic finance principles.

Murabaha meaning

Murabaha is a cost-plus sale. The seller tells the buyer what the goods cost and adds a disclosed profit margin. The price can be paid later in instalments.

In banking it usually works like this:

1. The customer asks the bank to buy a specific asset, such as machinery, raw material or a car.
2. The customer promises to buy it from the bank.
3. The bank buys the asset and owns it, at least for a short time, carrying its risk.
4. The bank sells it to the customer at cost plus an agreed margin, payable on a deferred schedule.

The price is fixed once the sale is made. If the customer pays late, the bank cannot raise the price as a conventional lender raises interest. Many Shariah boards allow a late-payment charge only if it goes to charity.

Where views differ:

• The binding promise. The Fiqh Academy and AAOIFI accept a promise that binds the customer alone. They do not accept a mutual binding promise that works like a sale concluded before the bank owns the goods. Critics say that in practice the promise makes murabaha look like a loan.
• Benchmarking to interest rates. Banks often price the margin against a conventional benchmark rate. Many scholars, including those who designed Pakistan's Islamic banking products, say this is permitted but not ideal. Critics see it as evidence that the product copies interest.
• Ownership in name only. All major standards require real ownership and risk before the resale. Scholars warn that if the bank never truly holds the asset, the contract fails.

Ijara meaning

Ijara is a lease. The bank owns an asset and lets the customer use it for an agreed rent over an agreed period.

Key features in the standards:

• The bank remains the owner and bears the risks of ownership, such as major damage not caused by the customer.
• Rent is charged for use, so it can start only once the customer has the asset.
• Rent can be fixed or reviewed periodically, if the method is agreed in advance.

Ijara muntahia bittamleek ("ijara ending in ownership") is common for car and equipment financing. At the end, ownership passes to the customer through a separate gift or sale. AAOIFI requires this transfer to be a separate promise or contract, not a condition built into the lease.

Where views differ: Some scholars accept ijara ending in ownership. Others say that the lease and the transfer, taken together, behave like an instalment loan secured on the asset. There is also debate about how far banks may pass insurance and maintenance costs to the customer.

Musharaka meaning

Musharaka is a partnership. The partners contribute capital, share profit at an agreed ratio, and share losses in proportion to their capital. A partner cannot be guaranteed a fixed return.

Diminishing musharaka is widely used for house financing in Pakistan:

1. The bank and the customer jointly buy the property, each owning a share.
2. The customer pays rent for using the bank's share.
3. The customer gradually buys the bank's units, so the bank's share and the rent fall over time.
4. Eventually the customer owns the whole property.

Where views differ: Supporters, including AAOIFI standards and Pakistani scholars at Darul Uloom Karachi, accept diminishing musharaka when it is properly structured. They require the sale of units to happen at the time of each purchase, not to be fixed in advance as a single combined deal. A group of Pakistani scholars issued a joint fatwa disputing the prevailing practice of Islamic banking, including these structures. They argued that the products work too much like conventional mortgages. Both positions have significant followings.

Mudaraba meaning

Mudaraba is a profit-sharing partnership where one side supplies capital (rabb-ul-maal) and the other supplies work and management (mudarib).

• Profit is split at a ratio agreed in advance.
• A financial loss falls on the capital provider, unless the manager was negligent or broke the terms.
• The manager loses the value of the effort.

Islamic banks in Pakistan commonly use mudaraba for savings and term deposit accounts. The depositor provides capital, the bank manages a pool and shares the pool's profit. The return therefore varies and is not guaranteed in the way a fixed interest rate is.

Where views differ: Critics point out that banks smooth the profit paid on these pools through reserves, so returns can track conventional deposit rates closely. Supporters reply that the contract still places capital at risk and that smoothing is allowed within limits set by the standards.

Comparison of the contracts

Related structures include salam (advance payment for goods delivered later), istisna (manufacturing contract), and tawarruq, which is disputed. The Fiqh Academy has rejected organised tawarruq, while some boards permit it in limited cases. Sukuk are often built on ijara, musharaka or mudaraba (see Sukuk explained).

Islamic banking in Pakistan

Pakistan runs full Islamic banks alongside Islamic windows of conventional banks, under State Bank rules and Shariah governance. The Federal Shariat Court has ruled against riba in the financial system and called for a transition. How quickly and how completely this should happen is still argued.

For how these products compare with conventional accounts, see Islamic vs conventional banking. For practical matters, see Payments, tax, Islamic banking. For the current policy rate context, see SBP rates and economy.

These contracts are about financing real assets and businesses. Questions about leveraged trading are separate. Leveraged forex and CFD trading can lose money fast, and its Shariah status is covered in Is forex halal? and Swap-free accounts.

Frequently asked questions

Is murabaha just interest with a different name?

Supporters say no, because the bank must own the asset and its risk before selling, and the price cannot grow with delay. Critics say practice often falls short of this. Scholars disagree, so ask a scholar you trust.

What is the difference between musharaka and mudaraba?

In musharaka every partner contributes capital. In mudaraba one side gives capital and the other gives management and work, and financial losses fall on the capital provider.

Is ijara car financing halal?

Many Shariah boards and AAOIFI standards accept ijara ending in ownership when the transfer is a separate contract. Some scholars object. We do not give a ruling.

Are profits on Islamic savings accounts guaranteed?

Under mudaraba the profit is not fixed in advance and depends on the pool's results. Check your bank's terms for how profit is calculated.

Who decides whether a product is Shariah-compliant?

Each Islamic bank's Shariah board approves its products, within State Bank rules and usually with reference to AAOIFI standards. Independent scholars may still hold different views.

Where can I learn the basic terms?

See Islamic finance principles and the Trading glossary.