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Types of Classical Islamic Financing Contracts

Prof. Dr. Monzer Kahf
10 August, 2026

Shariah Compatible Finance Contracts

While Shariah prohibits interest and other similarly unreal methodologies of financing, it holds on to the basic financing contracts that have been known to human beings since day one. It is difficult to call them “Shariah Alternative Contracts” because they are neither Shariah-invented nor alternatives to interest. They are real methodologies of finance that have always existed in all societies; they are financing as usual! Studying these contracts that are compatible with Shariah can help determine the exact boundaries of Riba and demarcate the objectives of its prohibition.

There are three major kinds of these “alternative” contracts: sharing-based, sale-based, and lease-based. From a historical point of view, Islamic financing contracts can be classified into two categories: classical contracts that have existed for centuries; their specific conditions are derived from the practice of the Prophet Muhammad’s community in Madinah, and hybrid contracts that have developed over the past half a century and are practiced in contemporary Islamic finance and banking.[1]  

What Are Classical Islamic Financing Contracts?

Classical writings on Shariah, some of which date back twelve centuries, mention three essential sharing-based financing contracts: equity sharing (musharakah), equity sharing with a silent partner (mudarabah), and crop-sharing (muzara’ah). They also mention three sale-based financing contracts: deferred or installment payment sale (al bay’ al ‘ajil), forward sale with cash advance (salam), and manufacturing financing sale (istisna’). Lastly, classical writings also mention leasing (ijarah) as a form of financing. All these seven contracts are within the group of contracts that is known in the literature as the nominate contracts (al ‘uqud al musammah).

1- Sharing Financing Contracts

Equity sharing may be de facto or a result of a contract that aims at making profit. De facto equity sharing happens either involuntarily, such as between heirs who share the ownership of property bequeathed to them, or voluntarily, as when a person buys part of an indivisible asset such as a horse or a plot of land that is marked by the county master plan as one indivisible unit. De facto equity co-owners are independent of each other; no co-owner is authorized to make any decision regarding the property of the other. Consequently, the use of the indivisible asset is divided between the owners in proportion to their properties, which makes co-ownership a form of time-sharing. In contemporary Islamic finance, de facto equity sharing (or co-ownership) is used as the foundation for creating sukuk and a secondary market for Islamic financial leases.

On the other hand, contractual equity sharing creates a partnership that aims at profit-making. This, obviously, requires an agreed-upon process of decision-making. Hence, contractual equity sharing implies an authorization by each partner to the agreed-upon manager, who may or may not be one of the partners, to make decisions on behalf of all partners regarding the use of their properties for achieving the partnership objectives. Management in equity sharing is undertaken on the basis of the wakalah (agency or empowerment to take decisions) contract. This has an important implication that characterizes contractual equity sharing as a contract that can be dissolved at will, because you cannot force a person to maintain empowering others to decide for her/him. In other words, a partner can withdraw from contractual equity sharing at any time provided, of course, that such a withdrawal either does not hurt other parties or the withdrawing party is willing to compensate them for any harm caused by her/his action.

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In contractual equity sharing, the contributions of partners may be of the same or different kinds. When all partners provide properties and management,[2] the contract is called musharakah; but when the contributions of partners are of different kinds, such as one puts in property and the other puts in only managerial work, or one puts in land and the other provides the farming, we then have mudarabah and muzara’ah respectively.

In other words, musharakah, mudarabah, and muzara’ah are variants of the contractual sharing contract. Capital can be money, goods or inventory, or fixed assets, but it cannot be a debt. Debt cannot be used as capital because, by its nature, a debt does not produce value added. A debt is neither a factor of production, nor is it capable of producing increments or profits. What can a manager do with a debt, it being a liability on another person? A quick answer may be to collect it and use the money for trading, but the moment it is collected, it is no longer debt. Certainly, it is permissible to request a manager of an equity-sharing contract to collect a debt, and once the cash is on hand, it can be taken as principal. In other words, because a debt is not liable to grow or even to change, it cannot serve as principal in an equity-sharing contract. This is despite the fact that a debt is an asset—but alas, a non-growable asset.

Furthermore, according to Shariah, people who share contracts must always share profits under all and any potentialities. Profit-sharing can take any ratio in recognition of partners who work more than others, but because a loss is defined solely as a reduction in principal by accounting standards, losses must be distributed in accordance with the shares in capital. Any condition otherwise is null and void. This is not the case in most Western commercial laws, whereby it is permissible, in partnerships, to distribute losses at ratios different from the ratios of capital contributions.

Musharakah is an equity-sharing contract in which each partner provides capital and management. In musharakah, the wakalah in management does not invalidate managerial contributions of other partners. Furthermore, in musharakah, partners must share the net profit according to the agreement, while losses are distributed only according to capital shares.

Mudarabah is a special case of musharakah whereby a sleeping partner provides capital but does not share in management, while the active partner does not provide any capital but puts in all the managerial work of the contract. Like musharakah, net profit is subject to distribution according to the agreement, but losses are in proportion to capital, which is all provided by the sleeping partner. In other words, in mudarabah, the sleeping partner bears all the losses.

Muzara’ah is a partnership on crops between a landowner and a farmer. Here, the gross revenue, not the net profit, is distributed according to agreement, and land is due back to its owner at the end of the contract. The essential two features of muzara’ah are: 1) distribution of gross profit; and 2) the return of the fixed asset to its owner as is. These two features serve as a basis for creating a contemporary Islamic financing contract outside agriculture. An example of such a gross revenue-sharing contract in financing is financing the ownership of infrastructure, such as a toll bridge, an airport, or a railroad project, on the basis of a percentage of its gross revenues.

2. Sale-Based Financing Contracts

There are three major sale-based financing contracts that are discussed in the classical literature on Shariah: deferred or installment payment sale, forward sale with immediate payment, and manufacturing sale. Deferred or installment payment sale financing is practiced daily by all businesses in every corner of the world; it requires immediate delivery of the property or service sold with delayed or periodic payments. When an employee accepts payment at the end of every two weeks, she is financing the employer by giving him labor services against deferred payment. The same is done by a wholesaler who gives three-month credit on merchandise delivered to a retailer.

The permissibility of deferred payment financing sale is mentioned in no less than the Qur’an itself. Verse 2:275, reads: “They [Riba takers] say: ‘Sale is just like Riba,’ but God has permitted sale and forbidden Riba.” The word sale in this verse refers to financing sale, because financing sale may be confused with interest lending, and a claim then may arise that they are similar. On the other hand, cash-payment sale is very remote from interest lending and has no similarity to it whatsoever. What is obviously similar to interest lending is deferred payment sale at a price that is higher than the cash price. Interestingly, the Qur’an did not degrade this claim or accuse it of irrationality in this verse.[3] This implicitly means that some similarity is acknowledged, yet the Qur’an quickly directs attention to the permissibility of this kind of sale that is similar to interest lending, and the prohibition of the latter. While a certain similarity is acknowledged, there are differences that warrant the permissibility of deferred payment sale-based financing and the prohibition of interest- and loan-based financing. This is why the overwhelming majority of scholars argue that the permitted sale in this verse is deferred payment financing sale. This is also supported by the fact that this permissibility of Verse 2:275 is followed, a few verses later, by Verse 2:282, which deals with confirmation and documentation of debts, because deferred payment sale creates debts that, similar to the debts of interest lending, require documentation.

Another implication of Verse 2:275 is that financing (with a return) is permissible and recognized in Shariah. While the verse condemns interest-based lending, it approves a kind of sale that fulfills the same objectives, including giving a reward for the time value of the sold commodity. In other words, the Qur’an establishes a very important rule: sale-based finance arrangements are an acceptable and rewarding usual business activity, while riba is prohibited. This plainly means that the creation of debts is not something that is discouraged or disliked in Shariah, and avoidance of creating debts is not an objective of the prohibition of riba.

This conclusion is important because of the confusion that is circulating in Islamic finance conferences, meetings, and circles that “Islamic finance is asset-based in contrast to debt-based finance.” The fact, as practiced in contemporary Islamic financial institutions and instruments, is: Islamic finance is debt-based sale financing much more than it is venture capital (musharakah) financing, and these practices rely on Verse 2:275. These practices create sale-established debts in contrast to interest-lending debts. Therefore, we need to rephrase that confused assertion, as this paper argues, to make it read as follows: Islamic financing is asset-based because it deals with real goods and services by means of contracts that create either debts or asset ownership.

There are a few apparent and multifaceted similarities between deferred-payment sale at a higher price than the cash price and interest lending when the loan is used to finance the execution of a cash sale of an asset. First, in both cases, the purchaser gets the asset or goods at the time of the contract and pays later. Second, the amount she will end up paying may be about the same in both transactions, i.e., the deferment-related increase in the price may be equal to the amount of interest paid on the loan. Third, the seller gets compensated for the time span between the contract and the maturity of the debt, and the lender also gets compensated for a similar time span. Finally, a debt is created in the amount of the deferred price that is higher than the cash price, or in the amount of the loan plus its interest.

On the other hand, the major difference between interest financing and sale-based financing is that interest financing is done in a loan contract that stipulates that a debt may be assigned increments, while sale-based financing recognizes that only goods and services may have different prices depending on the dates of payment and delivery. In reality, a debt, because of its own nature, cannot produce any increment. This is the ideological basis for the prohibition.

The implications of this difference are great.

  • First, accepting the unreal premise that debt may have increment requires the creation of another unreal assumption about the valuation of the increment, or the rate of interest itself.
  • Second, once debts have increment, it must be acceptable to reschedule them with increment, and there must be discounting with a reduction. These operations do not create value; they only transfer wealth from one to another.
  • Third, trading debts may become a huge operation in society, as it is in the West today; this is a purely speculative business with a zero sum as it only transfers wealth from one to another; it does not create added value, and it consumes a large quantity of human and material resources that are taken away from the production of real goods and services. The Shariah does not find in these transactions a methodology that promotes increasing the quantity of goods and services and the welfare of the economy. These speculative financial transactions do not increase the number or productivity of workers on production lines, of inventories on shelves, or of goods and services reaching consumers; they only enrich some individuals and impoverish others.
  • Fourth, lending-based finance does not allow the application of moral and social screening without additional cost and legalities (as a result of adding conditions that restrict the use of funds at the borrower’s end and creating monitoring procedures to enforce them), while moral and social screening is intrinsic to sale finance. Finally, the size of finance in the economy becomes detached from the real market in the case of loan-based financing, and it would expand on its own in isolation from real production and exchange.

Salam is another sale financing contract. It is a sale of deferred-delivery goods for a presently paid price or a sale on description of goods that do not exist at the time of contract. Its objective is to finance producers who will then be able to acquire the inputs they need and pay their current expenses. Obviously, this kind of sale financing requires a clear consensual agreement on the full specifications of the goods sold, determined date and place of delivery, and the amount of the price. Salam creates an in-kind indebtedness which carries not only a financial risk but also a commercial risk of price variations. In order to avoid price speculation, the Shariah does not allow selling owned goods before taking full possession of them. Because of the nature of its indebtedness, a successful use of the salam financing contract requires certain market conditions, such as stable or predictable commodity prices, adequate risk mitigation tools, and an efficient and active commodity market that enables the creditor to liquidate her positions soon upon delivery.

The last major sale-based financing contract is istisna’. It is a sale financing of fully described, specified, constructed, or manufactured goods against a price that may be paid at any time. It is a contract that can be used to finance producers or consumers depending on the consensual date of payment, and the seller does not have to be the actual producer. Istisna’ (manufacturing sale) is similar to salam in that both contracts are on the sale of goods that are not available at the time of the contract—they require future delivery. The only important difference is that istisna’ does not require advance payment of the price.

3. Lease Contracts

As a matter of definition, lease, or ijarah, financing is a sale of a usufruct for a given price that is payable at any agreed-upon date. The object of ijarah is a usufruct (a right to use an asset and take its benefits and then return it to its owner at the end of the agreed period) of long-living assets that are not consumable during the contract period. In Islamic lease financing, as it is in leasing as defined in other laws, the lessor is responsible for delivering the asset in usable condition and maintaining its usability throughout the lease period. The lessee is responsible for the rent and for returning the asset to the lessor at the end of the lease. Since the asset is entrusted to the lessee, she will be responsible for damages only in cases of abuse or negligence, but not for normal wear and tear.

It should be noted that while lease financing keeps the ownership of the asset in the name of the lessor, leasing is a debt-creating contract as the periodical rentals become a debt on the lessee, and this debt can be mitigated by all and any kinds of collaterals and securities. In many countries, tax systems and accounting standards distinguish between operational and financial leases. This distinction is basically related to who may get the benefit of deducting amortization allowances from taxable income and how to represent, accounting-wise, the parts of periodical payments that are assigned to paying for the principal of the leased asset. The Shariah does not assign much concern to differences between these two kinds of lease contracts as long as they both legally maintain the title of the leased asset in the hand of the lessor. This means that the same conditions and legalities apply to both financial and operational leases.

Furthermore, a lease contract may be combined with an offer to sell the asset to the lessee gradually. Gradual sale necessitates a gradual reduction of rentals to make them consistent with the changing distribution of ownership. The Shariah and Accounting Standards issued by the Auditing and Accounting Organization for Islamic Financial Institutions (AAOIFI)[4] recognize different versions of financial lease and accept this idea that a gradual transfer of ownership may take place along with the parts of the periodical payments assigned to buying the leased asset, even without a title change upon each payment.[5] Other considerations, especially those related to taxes, do not raise any Shariah red flag.

The leased asset can also be sold, used as collateral, and traded in an exchange market as long as the lease agreement remains untouched and the rights of the lessee are protected. The new owner becomes entitled to the rentals from the day of transfer of ownership. Lease financing can also be contracted for an asset that is fully described, but not yet in existence. Additionally, the rent may be structured in any consensual manner that fulfills the financing objectives of the parties. It can be paid as one lump sum in advance in order to finance the lessor, or at the end of the lease to finance the lessee. It can be spread over a number of years that does not have to coincide with the period of the lease, and rentals can be increasing or decreasing at a fixed or moving rate or at a rate that is tied to an external factor that becomes known before the beginning of each new rental period. The characteristics of the lease contract make it amenable to different formulations that serve the multiple financing objectives of the lessee and the lessor. This flexibility provides ample room for creativity in Islamic securities, which has allowed the issuance of different kinds of sukuk over the last few years.

Finally, according to Shariah, an owned usufruct is an independent property that stands on its own and can be subject to any and all kinds of transactions that apply to any property. The implication is that usufructs can be represented in securities and floated in an exchange market. Hence, they can create a new form of investment tool. This forms the Shariah basis for different kinds of sukuk (Islamic bonds) that represent usufructs only.

4. Characteristics of Classical Financing Contracts

There are six main characteristics of classical Islamic financing that are presented briefly below:

  • First, Islamic financing is usually described as asset-based financing because it is based on owning goods and assets. This is apparent in sharing-based financing, as the ownership of the funds provider is carried over to the new properties purchased with her funds. It is also obvious in lease financing, since the lessor deserves rent because she owns the leased property. In sale-based contracts, this characteristic takes a slightly different form: sale financing requires that a seller owns a commodity, an asset, or a property and has full possession of it, and then she sells it at a higher and deferred price. Therefore, sale financing is also asset- or goods-based because it begins with assets, although it ends up creating debts.
  • Second, the investment asset must be of the kind that may grow or create an increment either by its own nature or by the effect of real market forces. All such properties can be assets that may entitle the financier to receive a return, including goods that may be sold, physical assets that may be used in a special manner to produce goods and services, and intangible assets such as patents and trademarks that may be applied to a production or marketing process. On the other hand, debts and cash in demand deposits are assets that do not provide such an entitlement.
  • Third, owning productive assets or goods and services, while a necessary condition in Islamic finance, is not alone sufficient. It must be coupled with another condition to make the financing Islamic. This condition is that we look at actual, real-life, genuine return. In other words, the return of the financier is determined in the actual market. Accordingly, return on sharing-based financing is determined in the market of the goods and services produced and sold and in the market of the inputs of the firm, return to lease financing is determined in the usufruct market, and return to sale financing is determined in the market of future prices of goods and services.
  • Fourth, contractual justice, fairness, and balance characterize classical Islamic finance contracts. These characteristics are expressed in several ways: free negotiation, consensual agreement, distribution of profits per agreement and losses per capital shares, and prohibition of misrepresentation, ambiguity (gharar), and excessive pricing (ghabn).
  • Fifth, Islamic financing includes intrinsic moral and social commitment and screening. Determining what to finance is an important issue in Islamic finance because it is channeled through producing, owning, selling, or leasing, all of which make the finance provider involved directly in the production and sale of whatever she finances. Hence, the moral and social screen is integrated into the process of Shariah-compatible financing itself and is not an imposed addition. The Shariah prohibits the production and trade of commodities and services that are condemned on either moral grounds or on the basis of their social and environmental harm, and according to Islamic finance, you cannot finance them because you cannot produce or own them!
  • Finally, Islamic finance contracts are flexible and amenable to creating hybrids. This is discussed below.

It is interesting to note that, after revisiting all the classical Islamic finance contracts, they are not specifically Islamic! In the sense that these are normal contracts people of all faiths, colors, races, places, times, and ages have been using and practicing all along. There is nothing in the basic features of these contracts that is uniquely or extraordinarily Islamic. They are the same financing contracts that existed before Islam and that everybody uses and practices. These contracts are known in the West, known in the East, and known everywhere in present days and past days. They are simply business as usual.

The important difference between Islamic finance and debt-based finance, which is dominant in the West today, is that Islamic finance does not accept being based on unreal assumptions or illusions: that money, given as debt, increases in the properties of others while in reality it does not grow; that a market may exist to trade debts while in reality this market is fabricated; and that a rate of increase (or a price of time) may exist for a loan while this is a pure illusion! Islamic financing contracts may be considered naively simplistic but they are formidably real and down to earth with all its crude truth.

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Reference:

This series is based on a paper published by Dr. Monzer Kahf in 2006.

[1] It should be noted that the Shariah is not coded as articles of law in a manner similar to legal codes in the Western world, because Islam does not establish a religious hierarchy that is authorized to give the law. Rather Shariah rulings, made over time, are found in the writings of Shariah specialists/scholars. This is why those seeking Shariah guidance or precedents must search for what is known as “nominate contracts” in Shariah literature; that is the contracts that are mentioned in the famous writings of Shariah scholars over the last twelve centuries or so. It is also the main reason why Islamic banks and financial institutions resort to appointing their own Shariah advisors or Shariah advisory boards.

[2] In the classical literature and Mudarabah and on sharing in general, jurists use the term ‘amal [work]; it mainly means managerial word in the area of decision taking but it may also include physical labor as known in craftsmanship where the manager and worker are same and one person.

[3] Interestingly, such degrading style is used in the Qur’an in many other occasions whenever the unbelievers offer a weak or irrational argument. For instance, in many verses of arguing with opponents the Qur’an uses phrases like: “ . . . will they not understand?” “ . . . you may understand,” “ . . . do you not understand?” “ . . . in order that you may rationalize” “… have you no rationale?” “ . . . if only you have reason,” “… don’t you reason,” “ . . . so that they may have mind to rationalize with!”

[4] A voluntary non-binding professional organization of the industry based in Bahrain. It maintains high respect among Islamic banks and financial institutions.

[5] The Accounting and Auditing Organization for Islamic Financial Institutions, Shari’a Standards, 2003. Standard No. 9.