This is a form of financing that is used to facilitate the purchase of an asset. This asset usually includes the purchase of a home or another type of business expense that is too large to be afforded by one individual. The Diminishing Musharakah starts with the client asking the bank to finance the purchase of an asset. The difference here is that in this form of agreement both the client and the bank are partners, which means that usually the bank puts 80% of the total asset’s cost and the client usually puts 20%. Of course, the percentage of investment of both parties can change and is left to negotiation, but the client will put something down, as the idea is to finance the purchase of the asset.
After the funds have been allocated, the bank goes into the market and purchases the asset. The client gets the right to use the asset and for this contributes to the bank, which owns most of the asset, as it invested more money onto the purchase. The client will pay these contributions over a predetermined period. The amount of contribution however diminishes over time, and therefore it is called a Diminishing Musharakah , where Musharakah means partnership.
The other requirement of such type of contract is that the bank splits its ownership of the asset into a given number of units, which depends on the length of the contribution period. If the contribution period is 10 years and the contribution is paid each month, then we have 10 years *12 months=120 total contributions. The bank splits its part of the ownership onto 120 units. Each month, the client pays rent and purchases a part of the bank/s share of the asset. This purchase is done at the current market value, so both the client and the bank share risk in the possible value change of the asset over its lifetime. The value of the asset might increase, or it might increase, point is that all that is factored onto the pricing of the purchase of the individual units of the bank’s ownership over the asset.
The idea of the Diminishing Musharakah is that as time goes by and the client purchases more ownership units out of the bank, then the clients diminish. This is because the bank is left owning fewer and fewer ownership parts of the asset. Think of the ownership parts as shares, in conventional finance. The client buys out the bank’s asset over time, and hence the bank charges less rent as it owns fewer and fewer shares of the asset.
During the last contribution period, the client buys the last ownership part of the bank over the asset, and hence the asset is owned 100% by the client. The client then does not have to contribute to the bank anymore as the client now owns 100% of the asset.