«ISLAMIC BENCHMARKING: AN ALTERNATIVE TO INTEREST RATE (Evidence from Home Financing in Malaysia) Ali Rama1 Wisnu Wardhana, Farid Kurnia Rahman, Ilham ...»
The periodic rental amounts will be jointly shared between the customer and the bank according to the percentage share holding at the particular times which keeps changing as the customer redeems the financier’s share. The customer’s share ratio would increase after each rental payment due to the periodic redemption until eventually fully owned by the customer.
Muhammad Taqi Usmani basically agreed on the implementation process of Musharakah Mutanaqisah Partnership. They agreed that the product could help the people to less rely on other financing facilities such as the BBA, Murabahah etc. The scholars agreed that it is best to implement Musharakah Mutanaqisah Partnership for house financing or machinery financing whereby both assets can be leased out according to agreed rental. Joint ownership of a house or machinery is accepted by all schools of Islamic jurisprudence since the financier sells its shares to the customer (See Taqi Usmani 2002).
5. Data Specification In this study, data panel has been used to compare rental rate and interest rate during 1995 to 2004. This study chooses Kuala Lumpur and Johor as place to look into. These places were chosen because Kuala Lumpur is capital city, whereas Johor is far to capital city. The study also applied Based Lending Rate (BLR) data to compare to rental rate.
6. Methodology This study wants to examine the relationship between rental rate and interest rate.
Correlation method is used to determine the relationship of rental rate and interest rate. The direction of relationship and the strength of relationship between two variables can be understood through this method. Hence, this study is expected can explain the relationship between rental rate and interest rate.
In general statistical usage, correlation or co-relation refers to the departure of two variables from independence. It also indicates the strength and direction of a linear relationship between two random variables. A number of different coefficients are used for different situations. The best known is the Pearson product-moment correlation coefficient, which is obtained by dividing the covariance of the two variables by the product of their standard deviations.
6.2. Sample Correlation
If we have a series of n measurement of X and Y written as xi and yi where i=1, 2, …, n, then the Pearson product-moment correlation coefficient can be used to estimate the correlation of X and Y. the Pearson coefficient is also known as the “sample correlation coefficient”. The Pearson correlation coefficient is then the best estimate of the correlation of
X and Y. The Pearson correlation coefficient is written:
86.3. Interpretation of the Size of a Correlation
Several authors have offered guidelines for the interpretation of a correlation coefficient. As Cohen (1988) himself has observed, however, all such criteria are in some ways arbitrary and should not be observed too strictly. This is because the interpretation of a correlation coefficient depends on the context and purpose. A correlation of 0.9 may be very low if one is verifying a physical law using high-quality instruments, but may be very regarded as very high in social science where there may be a greater contribution from complicating factors.
Along this vein, it is important to remember that large and small should not be taken as synonyms for good and bad in terms of determining that a correlation is of a certain size.
For example, a correlation of 1.0 or -1.0 indicates that the two variables analyzed are equivalent modulo scaling. Scientifically, this more frequently indicates a trivial result than a profound one. For example, consider discovering a correlation of 1.0 between how many feet tall a group of people are and the number of inches from the button of their feet to the top of their heads.
7. Finding and Analysis
7.1. Comparison of Actual Rental Rate in Kuala Lumpur and Johor According to rental price and house price data which are taken from Annual Property Report of Malaysia, we can derive the actual rental rate. This rate provides us the actual condition of property market in Malaysia.
Table I shows us the historical rental rate in Johor and Kuala Lumpur from 1995 to
2004. We can infer that every type of house has different rental rate. The rate tends to be higher in the more luxury type. Condominium has the highest rate compared Single Story, Double Story or Double Story Semi-Detached type. Interestingly Single Story type has higher rental rate than Double Story in average. It indicates that the size of the home is not the only consideration to the determination of rental price.
9 In general, rental rate in Kuala Lumpur is higher than Johor. Based on the average of rental rate, Single Story, Double Story Semi-Detached and Condominium type in Kuala Lumpur is higher than Johor. This evidence explains that every place has different rental price depend on how strategic the place is. Rental rate has tendency to increase when the place is close to capital city.
Table 1 also provides the comparison between Base Lending Rate and Rental Rate.
Base Lending Rate constitutes the minimum rate which commercial bank charged to the housing loan customers. The rate that commercial bank charged to customer can be fluctuated until four percent (4%) above the BLR.
According to table 1, BLR is higher than rental rate in all of type of house except Condominium. This fact explains different perspective about rental rate and interest rate. In customer’s point of view, rental rate gives them an advantage. Lower rental rate will imply that they will pay less monthly installment than interest rate. Otherwise, bank will less attractive to use rental rate because it will give lower profit compared to the interest rate.
In addition, table 1 also shows an interesting result where in the period 1995 to 2004, the rental rate has a decreasing trend. This trend becomes good information for customers 10 which enable them to pay lower installment. Based on the standpoint of stability, rental rates tend to be more stable compared to interest rate. Even when the financial crisis in 1997 and 1998 where the interest rate has increased significantly, rental rates did not show a big fluctuation, even only increased around 1 percent. This indicates that the rental rate can be used as an alternative to replace the interest rate in terms of home financing because it was not too affected by monetary fluctuations. This is certainly different from the interest rate that is very vulnerable from monetary fluctuations which finally will affect the community life.
We argued that the increase of rental rate only will occur when endorsed by the increase in real economic activity in the area such as increasing the access to quality transportation (roads), infrastructure, the rise of new center of economic activities (markets, supermarkets, etc), university and as well as the development of an area.
Table 2 above shows the mean and standard deviation between Base Lending Rate (BLR) and rental rate for each type of house. It clearly shows that the BLR is more volatile than the rental rate.
7.2. Correlation of Base Lending Rate and Rental Rate Table 3 below shows correlation analysis between Base Lending Rate (BLR) and rental rate in Kuala Lumpur and Johor. It shows some interesting results. In General, rental rate has positive correlation to interest rate. However, Single Story is negatively correlated. It means that the interest rate goes up; rental rate of Single Story type tends to be decreasing.
Besides that, Single Story, Double Story and Double Semi-Detached have a weak and
Note: *,** denote correlation is significant at the 0.05 and 0.01 level (2-tailed) respectively.
In line with the analysis of correlation in KL, rental rate in Johor has also a positive correlation to interest rate. It means that when the interest rate goes up, rental rate in Johor tends to be increasing. Besides that, all types of house in Johor have a weak and insignificant correlation to interest rate whereas only double story has a significant correlation. It depicts that every changes in interest rate will affect indirectly to the rental rate in Johor.
A weak correlation between interest rate and rental rate in both different places shows that price and rental of real estate are not determined by interest rate. There are many factors influencing price and rental of real estate such as location, characteristic of the property, like floor size, number of rooms, type of house, etc.
8. Implication of Rental Rate in Home Financing Practice
8.1. Comparison of Home Financing Practice between Rental Rate and Interest Rate The different between rental rate and interest rate (BLR) also has an effect to home financing practice. Since Islamic Bank utilizes the same formula and method to Conventional Bank in calculating the monthly installment, customer will get advantage when the rental rate is lower than interest rate and vice versa. Interestingly, Islamic scheme will be similar to conventional one when rental rate is equal to interest rate. In this case, the amortization schedule becomes similar between Islamic home financing and conventional mortgage.
Suppose that you want to buy RM 300,000 house by having only RM 60,000 cash on hand. The rental rate price at that price is RM 1,000 per month. You are considering applying RM 240,000 financing for 10 years either from Islamic or conventional bank that gives you 6 percent interest charge.
By applying the same formula to conventional loan4, the amount of monthly payment which customer must pay is RM 2,249.88 and total house price that customer have to pay in 10 years is RM 291,586. Furthermore, it is equal to 4 percent annual percentage rate (APR).
Table 4 below provides the variance of monthly payment and total payment which customer should pay. According to the table, MMP’s customer will pay less than conventional when the annual rental rate5 (ARR) is lower than Annual Percentage Rate (APR) of conventional bank.
If conventional bank imposes 6 percent interest rate, customer has to pay RM 2,664.49 for monthly installment and RM 319,739.05 in 10 years. Interestingly, MMP will have similar arrangement when the annual rental rate is the same with conventional APR, namely 6 percent.
Nevertheless, this amount is higher compared to Musharakah Mutanaqisah when the annual rental rate is 4 percent that gives you RM 2,429.88 for monthly installment and RM 291,586 for total payment. Otherwise, MMP will be more expensive when the annual rate is more than conventional APR. if the annual rental rate is 8 percent, the customer’s monthly payment is RM 2,911.86 and RM 349,423.47 for total payment.
4 See appendix 1 5 Annual rental rate is similar to Annual Percentage Rate (APR). it is used to distinguished the conventional term of APR.
8.2. Comparison of MMP in Kuala Lumpur and Johor According discussion before about disparity of rental price in every place, it will make variation of rental rate. Thus, the bank cannot charge similar rate to all customer. The bank should consider of the house that customer want to buy. Different place will give different rental price. It will impact to variation of rental rate, monthly payment and total payment that is imposed to customer.
Comparing MMP financing between Kuala Lumpur and Johor, we can find that a place that in capital city or close to capital city tends to have higher rental price than others.
Hence, it will give higher rental rate, monthly payment and total payment.
Suppose that a customer is considering buying a RM 150,000 house between Kuala Lumpur and Johor. The rental price in Kuala Lumpur is RM 716 per month whereas Johor is RM 385. Then the bank gives financing RM 120,000. Due to difference in rental price, the bank cannot charge the same rate between Kuala Lumpur and Johor. Table 6 below shows that the bank will give 0.48 percent rate per month in Kuala Lumpur and 0.26 percent rate in Johor. Higher rate in Kuala Lumpur will make the customer pays higher monthly payment and total payment compared to Johor.
Hence, we can conclude that every place with different rental rate price will have different rental rate, monthly payment and total payment. Furthermore, the place that close to capital city tends to have higher rental price and be more expensive compared to the other.
9. Conclusion and Recommendation 9.1. Conclusion Interest rate as cost of capital which is used widely has given bad effect to economic circumstance. On the other hand, rental rate appears as an alternative to replace interest rate.
Even though rental rate cannot replace perfectly, it can be applied to some form of contract such as home financing which is based on Musharakah Mutanaqisah contract.
This paper has shown that rental rate will be different in every place. They tend to be higher in the place that is near to capital city or more luxury type. According to correlation analysis, in general this paper finds that rental rate has positive and weak correlation to interest rate. However, Single Story in Kuala Lumpur has negative correlation and condominium in Kuala Lumpur has strong correlation to interest rate.
Furthermore, rental rate is lower than interest rate in general, except rental rate of Condominium that is higher than interest rate. By employing similar formula and method to conventional bank in calculating amortization schedule, this paper describes that MMP customer will have lower payment than conventional one. MMP has possibility to be more expensive if rental rate is higher than interest rate. Interestingly, MMP will be identical to conventional when the rental rate is similar to interest rate.
This paper also compares the MMP when it is applied in Kuala Lumpur and Johor. By having different rental price and rental rate, it will affect the disparity of monthly payment and total payment in those places. Hence, this paper concludes that rental rate can be used as an alternative to interest rate because it has some advantages and reflect the market value of the house.