Islamic finance is gaining popularity in key markets
According to a Morgan McKinley research, the global value of Islamic banking assets is forecasted to reach $6.5 trillion by 2020.
Islamic finance has gone mainstream and is rapidly growing in its key markets. The numbers don't lie. According to a Morgan McKinley research, the global value of Islamic banking assets is forecasted to reach $6.5 trillion by 2020, as compared to $150 billion in the mid-1990s. This says a lot about the growing popularity and global acceptance being garnered by Islamic finance.
What is Islamic finance?
While most of you may get lost in terminology, understanding how Islamic finance works is not as complicated as it seems. The first step is to know what the basic principles of Shariah-compliant financing are.
Islamic finance is a financial system that complies with Shariah law, which prohibits taking or receiving interest or 'riba'. The institutionalisation of Islamic finance started in the 1960s, with the primary aim to meet the finance requirements of Muslims in conformi ty with the Islamic principles of Shariah.
In the UAE, Islamic finance has also gained in popularity amongst non-Muslim expats. This is due to the fact that many Islamic banks offer good deals and terms on a range of finance products like mortgages, auto finance, personal finance and more. Irrespective of whether you're a Muslim or not, you can take advantage of the best Islamic credit cards, accounts and finance products available in the market.
What is Murabaha and how does it work?
Murabaha is a commonly used interest-free financing tool in Islamic banking. When obtaining finance through Murabaha, you enter into a contract with the bank, wherein the bank purchases a specific asset or goods and sells them to you at a pre-determined price inclusive of the bank's profit margin. You agree to pay the Murabaha price in monthly installments for a mutually agreed upon tenure. Since Murabaha uses the basic principles of cost and sale at a profit, it's also know as cost-plus financing.
The way Murabaha works is quite similar to a rent-to-own arrangement wherein the bank holds on to ownership of the asset in consideration, until you have paid off the loan in full.
Here's a simple example of how Murabaha works in principle. Let's assume, you require Dh1,000,000 to purchase a house. You approach an Islamic bank for home finance. The bank agrees to finance the transaction, by offering to sell the house to you for Dh1,100,000 including Dh100,000, which is the bank's profit. You are required to pay for the cost of the house inclusive of the bank's profit through a deferred payment structure spread over the tenure that you and the bank agree upon. Once you pay off this amount, the bank will transfer the ownership of the house to you.
When is Murabaha used?
Murabaha is a popular form of Islamic finance and is widely used for financing the purchase of goods or assets, like a house, new or used car, equipment, furniture etc and is used for loans with longer tenures.
What is Tawarruq and how is it different?
Tawarruq is also commonly known as Reverse Murabaha or Commodity Murabaha. Essentially, Tawarruq takes the basic concept of Murabaha further to include another stage in the financing process.
The first stage of financing in Tawarruq is the Murabaha stage in which you can unlock cash by buying a commodity held by the bank under a deferred payment agreement.
The second stage will involve you selling your share in the commodity either directly in the market or through the bank, wherein the bank acts as an agent. You can then pay the bank back in installments or in lump sum. As this process involves a Murabaha transaction and then its reversal, hence the alternate name 'Reverse Murabaha'.
The involvement of commodities in this type of financing is done to meet the basic principle of Islamic finance, that there must be an underlying tangible asset in any finance transaction. The bank can use various traded commodities to validate Tawarruq transaction, like precious metals and non-precious metals amongst others, thus, the name, Commodity Murabaha.
For example, you need Dh90,000 to finance your upcoming house rent payment. You approach a bank, which agrees to provide you the said amount through Tawarruq financing. The transaction will involve you buying Dh100,000 worth of a commodity, like a non-precious metal, from the bank to be paid back in 12 months. The bank will then act as your agent to sell the commodity immediately, for Dh90,000 for spot payment. Effectively, you would get Dh90,000 in finance to be paid back to the bank at the end of one year, inclusive of Dh10,000, which is the bank's profit.
When is Tawarruq used?
Tawarruq helps fill the gap for short-term financing of intangible necessities like education, travel, house rent, working capital etc. where there is no physical asset involved. It can help you get instant access to cash locked up in these obligations.
The author is the founder and chief executive officer of Souqalmal.com. Views expressed are her own and do not reflect the newspaper's policy.
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