Benefits and Costs of Financial Products for the Poor

As professionals in the financial inclusion space, we work with a common assumption that formal financial services are better than informal products. Despite recognizing that the poor tap into a variety of informal services, such as savings clubs, loans from family and friends, money hidden under the mattress and credit from moneylenders, we believe implicitly that formal services will do the job better. We define success in the financial inclusion realm as a shift from informal product usage to formal product usage. 

But are our assumptions correct?  To answer this, CGAP hired Bankable Frontier Associates to revisit the Financial Diaries households showcased in Portfolios of the Poor. Orlanda Ruthven, Stuart Rutherford and Daryl Collins collected data about how much households used financial instruments and what they paid in fees with the Indian, Bangladeshi and South African households. We updated their financial information to 2010 and asked additional questions to get the fully loaded cost of each financial service in terms of fees, interest, time of travel and transaction and cost of travel.   As you can read in the deck, we found, in fact, that informal products do indeed sometimes win out over formal ones. 

By analyzing savings, borrowing and insurance usage patterns across formal and informal products, we found that even with increased access to formal products, the poor do not automatically favor formal services at the expense of their informal counterparts. This suggests that the role of introducing formal products to low income households is to expand the financial options of the poor, by providing new options for different purposes. Rather than seeing informal and formal instruments as alternatives, we should see them as complements.  

Consider the classic example of a moneylender loan. We assume that this informal financial option is far more expensive for the poor than formal options. On an APR basis, the moneylender’s 30% per month interest rate balloons up to 2230% per annum and dwarfs the comparative MFI lending rate of 70% per annum.   

This simplistic picture changes, however, when we look at the costs of financial services as part of a complex portfolio, instead of on a stand-alone basis. When we consider both the size and maturity of these two loan types and how they might affect an entire portfolio over a period of time, some formal credit expenses can actually dwarf informal credit. In the table and paragraph below, we demonstrate how examples of both instruments work in an average monthly portfolio over a period of 4 months.

In the South African Financial Diaries sample, less than 1 in 4 respondents earning about $730 a month avail themselves of a bank or MFI loan. However, nearly 50% of the sample used “store cards”, i.e. credit cards unique to specific retailers to be used only with that type of store. In our year-long observations, we found that most card-holders use these cards continuously and pay down the debt at the rate of about $30 a month. In contrast, the majority of the sample used informal services, such as loans from friends, family and neighbors. Importantly, these households borrowed very small amounts (on average $4) and paid back the entire amount within a week with no interest.   In a similar vein, households that used moneylenders took out small loans (on average about $28, less than 5% of monthly income) infrequently (only once a year). Strikingly, they paid these loans back almost immediately. In this case, the high interest rate of 30% typically charged by moneylenders can be described more aptly as a small “fee” of about $8, just over 1% of monthly income.  

The overall impact on household cash flows over time can be seen in the table below. The table illustrates the share of monthly income paid to service (including fees, interest and repayments) formal monthly store card payments (4%), informal moneylender loans (0.6%), informal borrowing between friends and family (0.3%), and bank/MFI loans (rarely used), on average, over a period of four months.

The lesson?  An annualized interest rate is not the only parameter in determining how much borrowing costs poor households – the size, maturity and frequency of the loan matter just as much, if not more. 

This is not to say that decisions about whether to use formal services or not are based on loan terms alone. Formal credit holds an important place in a poor person’s portfolio.  Accordingly to what we found during the Financial Diaries, friends and family or a moneylender can rarely provide the loan size a bank or MFI can offer – a loan size big enough, in fact, to warrant payments over time, unlike small informal borrowings that can be paid back within a month.  Formal borrowing is therefore a complement, rather than an alternative to informal credit. 

In the next blog, we’ll review lessons we have learned from formal credit, savings and insurance formal providers and point out the gaps they can fill within the financial options of the poor.  In the meantime, download our deck to read more details about the study and its findings.