It’s the reasonable repayment plan-stupid!
23 February 2009
Many of my friends and family have been shocked, when I explained to them that microcredit loans often carry (what we would consider) usurious/oppressive interest rates. Many of them have asked me how ANYONE could justify interest rates of 30 or 50 or even 100%?
I have tried to explain all the factors that go into how a microfinance bank determines just how much interest it must charge in order to remain a viable business.
I go through the litany of factors contributing to the “high” interest rates—-the fact that it costs as much (or more) to make a $300 loan as it does to make a $10,000 loan; that in order to reach the poorest of the poor, the loan officers must often travel long distances on back roads in order to serve this population(because these borrowers do not usually have transportation to get to the banks); how a microfinance bank must cover its costs if it is to stay in business and continue to provide credit to the poor, that inflation rates must be accounted for in order for the banks to even recoup the original value of the loan. Usually, their eyes glaze over, they remain unconvinced and they find it difficult to get beyond their shock at the absolute level of the interest rates.
So, yesterday, I listened to a loan officer with ASDIR (Kiva’s field partner in Totonicapan, Guatemala) explain to a couple how they would have to repay their 30% interest loan in 12 monthly installments and (this is the key) that with each payment the total amount due on their loan would get lower and lower, until it was paid off.
That is when the differences between credit card debt which most U.S. consumers use to finance purchases and the microcredit consumer loans became crystal clear! It’s not about the absolute interest rates; it is about having reasonable repayment terms, which pay off the loan!
Let’s compare two loans of, say, $1000 —-one done the microfinance way and the other the American credit card way. The microcredit loan is made at the apparently outrageous rate of 50%, while the credit card loan is at a far more “reasonable” 20%.
___________ Microcredit American credit card
Loan Amount 1000 1000
Interest Rate 50% 20%
Minimum monthly payment ($107.59) ($16.67)
Total Payments in one year ($1,291.02) ($200.00)
Amount owed after 12 months 0 $1,000.00
Total amount paid in 5 years ($1,291.02) ($1,000.00)
Amount owing in 5 years 0 $1,000.00
Interest Payments to Bank $291.02 $1,000.00
With a microcredit loan, a loan officer evaluates the financial position of the borrower and develops a payment plan that is reasonable. It is a plan that gets them out of debt in a relatively short amount of time. In contrast, in recent years, the credit card way has been to provide people with a credit line, encourage them to make purchases on their card (up to their limit) AND then encourage/allow them to make only the minimum monthly payment. Paying off the card/the loan is NOT encouraged. Better for the banks to keep them paying interest only.
After one year, the borrower with a microcredit loan has paid off her loan and has paid a total of $291.02 in interest. After one year, the American credit card borrower has paid $200 in interest and still owes $1000 on the loan. After 5 years, the American credit card borrower has paid $1000 in interest and still owes the entire $1000. Meanwhile, the microcredit borrower may have taken out and repaid another loan or two, while the credit card borrower is still paying on the original loan!
Ends up the lower rates, but totally open-ended repayment terms are far more onerous for the borrower (and beneficial to the bank in the short term) than a significantly higher interest rate with clear and closed-ended repayment terms.
I don’t know if this will change the minds of some of my doubting friends and family, but, I think it illustrates how banks can charge interest rates high enough to cover their costs and risks, while still benefiting the borrowers who must pay the interest. It is truly a win-win, even if it may not seem like it at first glance.
For more information on microcredit interest rates: http://www.cgap.org/p/site/c/template.rc/1.26.2617
Entry Filed under: ASDIR, All, Guatemala. Tags: Kiva, Kiva Fellows, kiva microloans, microcredit interest rates, microfinance interest rates.
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1. Megan M | 23 February 2009 at 07:37
Awesome post Lori! I think we’ve all struggled with explaining interest rates, and this is a great way to tie it to something people in the developed world can relate to. I’m going to use this comparison next time I’m having trouble convincing someone that these “high” interest rates can and do make sense. Hope you’re loving Guatemala!
Abrazos,
Megan M
2. Boris | 23 February 2009 at 07:52
Enjoyed your post, Lori. I’m certainly facing the same issues when trying to explain the high interest.
However, I’m not sure if yours is a fair comparison, as it’s comparing two different things.
With credit cards – granted, Americans have the option of just paying the minimum balance, while people in the developing world do not. And certainly, the banks earn more if you simply continue paying the minimum amount. Which, by the way, does include a portion of the principal – so I’m not sure if it’s accurate to say that after 5 years, you owe the original amount.
But consumer credit cards are not the same thing as business loans. So I’m not sure if this is a justification of why MFIs charge higher rates. I think it’s important to compare a business loan in the U.S. with a business loan in Guatemala or Tajikistan and then note the differences on that.
As you mentioned, when you make that comparison, you see all of these factors that contribute to the higher interest rates:
- higher costs (e.g. traveling, etc.)
- smaller loan sizes
- currency fluctuations
- taking a bigger risk on non-collaterized loans
Just my $0.02c
3. Neil | 23 February 2009 at 11:01
While I’m aware that the high cost of operating an MFI make high interest necessary to say the least, some of you assumptions about credit cards are wrong.
Credit cards do have a minimum payment that includes some principle (usually between 2% and 5% of the outstanding balance), so the debt does eventually go away, though certainly not as quickly. And of course, you’re right that people are encouraged to run them back up.
That said, there was a post on this blog recently (How Risky Are MicroFinance Borrowers?) which talked about repeat borrowing – where one specific client in Tajikistan was mentioned as being on their fifth loan. This was presented in a positive light, as meaning that a credit history was being built, but could it not also mean that that client now suffers from the same problem as most westerners – a life perpetually in debt? That’s not really all that different from the credit card model, unless each loan really is increasing their revenue.
4. lorigib | 23 February 2009 at 11:53
microcredit can be extended for “consumer loans” as well as for “business loans”. the example i was listening to involved a couple who were buying a new stove because the old one had broken. (not your normal kiva loan, but still a microcredit loan, extended to someone who would not qualify for a credit card loan (a blessing in disguise!))
my point was that in the anonymity and the “make as much money as fast as you can” mentality of the current credit card/banking system…………we accept their program as, somehow, “reasonable”, and are aghast at the HIGH interest rates that microcredit lenders charge. our focus solely on the interest rate being charged does not tell the whole story.
5. Brenda | 23 February 2009 at 14:29
“Microloans have been made in developing countries for more than 30 years. Bangladeshi economist Mohammed Yunis made the first one of about $27 from his own pocket to 42 women hoping to buy bamboo to make furniture. He later formed the Grameen Bank, which is now one of the world’s largest microlenders and shared the 2006 Nobel Peace Prize with the founder.”
from a Boston Globe article published Feb. 17, “Recession ups US demand for 3rd world type loans” I read about Mohammed Yunis awhile back. Seems like he has a greater legitimate claim on the Nobel Peace Prize than Henry Kissinger did. Just sayin’
gibby, you’re ahead of the curve, as usual. keep going
6. Unilove | 23 February 2009 at 23:48
Another point is, is that these entrepreneurs would normally be denied any access to credit or loans, and often would have to resort to remaining in poverty or dealing with loan sharks and the black market. These MFI loans are a blessing and an opportunity normally denied them. Access to some credit is better than no access to credit…
7. Drew Loizeaux | 24 February 2009 at 01:23
Hey Lori – great post!!!
As others said above I also have had trouble explaining the need for interest rates and the need for them to be so high by western standards in Microfinance. This was a very clear and easy to understand example. Thanks! I am going to send this to a few still doubtful friends.
-Drew
8. Rob | 24 February 2009 at 23:06
Lori, thanks for the analogy. It’s always helpful to have some context and comparison.
To Neil’s point, yes many microloan clients are repeat customers. But this is no different than a small business owner anywhere else in the world with access to a revolving line of credit. Cashflow is uneven and businesses occasionally have a need for large amounts of cash (for example to buy inventory) which is then paid back as sales materialize.
As usual, reality is somewhere in the middle ground with microfinance having both its pros and cons. With more and more MFIs establishing microdeposit programs, the hope is that eventually business owners can diminish the need for credit. It’s not yet perfect, but then the perfect is sometimes the enemy of the good.
9. Michael | 9 March 2009 at 20:08
One other consideration is that these countries often have double-digit inflation, so what looks like a really high interest rate ends up being fairly normal when adjusted for inflation.
My wife is from the Philippines, and mortgages there are often written with 20% interest rates. With 10% inflation that’s not so bad.