Rental index rate as an alternative to interest rate in Musharakah Mutanaqisah home financing : A simulation approach

Purpose This paper aims to propose a new pricing alternative called Rental Rate Index (RR-I) that captures the true value of property to be used by Islamic banks in Musharakah Mutanaqisah (MM) contract for home financing. Design/methodology/approach By formulating a profit rate based on Rental Index (RI) and House Price Index (HPI), the proposed rate eliminates conventional profit rate benchmarking, and, at the same time, suggests a fair, equitable and sustainable financing. This new RR-I (measured by RPI/HPI) enables computerization of the MM system in home financing to be easily implemented. A financial simulation is developed to demonstrate the feasibility of this newly proposed rate. Findings This newly proposed RR-I is found to be more stable, having less fluctuations, resilient to macroeconomic conditions and yet comparable to the conventional interest rates, without depending on them. It can also be regarded as a rate that is fair and sustainable to both the customer and the bank, as it measures the actual rate of return to both parties in MM contract. Research limitations/implications The paper confines one contract, namely, MM, as it is claimed to be more Shariah-compliant than others. Practical implications The finding also sheds some light on the recommendation by Bank Negara Malaysia, which is to consider RR that is more indicative of the actual rental price while taking into account the competitiveness of the product. (BNM, 2007). Social implications This paper wreaks customer patronage in selecting the contract of home financing. Originality/value This paper attempts to resolve the issue of benchmarking RR to the conventional interest rate in the MM contract. Studies conducted on this issue via simulation approach are meager.