Islamic banking is based on Sharia law. Sharia law is the rules set according to the Koran and the teachings of Muhammad. According to Sharia law, Islamic banking is an interest-free banking system. In contrast to conventional banking, Islamic banking does not earn its money using interest. Islamic banking has three important models in which it earns money and functions. The three models are:
The most common model is called Murabaha. Murabaha is defined as a profit of sale mutually agreed upon by both parties (buyer and seller). An example is buying a car from a bank. Instead of charging interest, in Islamic banking, the bank will buy the car for the client and sell it at a profit; the client pays it back in fixed installments.
Ijarah means an exchange transaction whereby a known benefit from a specified asset becomes available in return for a payment; however, the ownership of the asset is not transferred. In simple terms, this is a leasing agreement where the asset is the leasing subject.
Musawamah refers to general sales of goods whereby the price of goods or commodity is bargained between buyer and seller. In Musawamah, the buyer has no idea of the cost of the asset (commodity) being sold and the seller is not obligated to reveal the cost of the commodity.
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