Finding the right halal contract

NOTE: Although we do not offer Islamic mortgage contracts at Azzad Asset Management—focusing instead on halal investments like the Azzad Ethical Wrap Program and the Azzad Funds—our financial planners want to make sure clients understand the depth and scope of financial products in the marketplace. As fiduciaries, we put the interests of our clients first and want to make sure they are making informed decisions in all facets of their financial lives.

The subject of financial contracts and their permissibility according to Islam is a complex one. Shari’ah-compliant contracts are regularly sought out by American Muslims looking to align their finances with their values. Just because a contract abides by Islamic principles, however, it does not mean that the agreement is the most appropriate form of contract for your particular needs.

A good example can be seen with the Halal home financing industry in the United States. The two most common forms of halal mortgages are murabahah (cost-plus) and musharakah (joint partnership) contracts. In a murabahah contract, the financial entity purchases an asset and then sells it back to a consumer at an agreed upon profit mark-up. A payment plan is created based on the new price. In a musharakah contract, a firm purchases the asset, and the consumer makes payments, which have built-in leasing and equity components, paying diminishing rents and acquiring more equity over the course of the agreed upon contract.

While both types of contracts abide by Islamic guidelines, the musharakah contract is more appropriate for long-term payment plans that typically come with home financing (usually 15-30 years). One issue area with murabahah mortgages is that if a borrower wants to sell the home during a contract period, he or she would still owe the agreed-upon profit to the lender.

For example, say an Islamic lender purchases a $500,000 home and then sells it to you for $750,000 with a contract term of 15 years. Imagine that seven years into the agreement, the home is worth $600,000 and you want to sell it. According to the structure of a murabahah contract, you would still owe the lender another $150,000, which is the remainder of the agreed upon profit markup. With a musharakah mortgage, the $600,000 purchase price of the home would be split between you and the lender, based on the equity position of each party. This is because in a musharakah contract, the bank and consumer are partners in the venture.

It may be hard to fathom why anyone would use a murabahah contract for any type of financing. But just like all other forms of Halal financing, there is a time and place to use it. Murabahah contracts are ideal for short-term contracts like car loans because they are much more cost effective to administer, and this can result in better rates for consumers and a quicker completion of the financing process. And of course, like all halal financing contracts, if a consumer were to default on a murabahah contract there would be no compounding of the amount owed. This type of compound interest, or riba, is the Qura’nic riba, which is viewed as the most egregious.

The larger point of Islamic finance is to create a more just economic and commercial system, but it’s important to remember that the contracts within this system are tailored towards certain circumstances and particular situations. As American Muslims, we should always keep our specific needs in mind when selecting a Halal financing solution.

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