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To maintain and increase its services over time, an MFI must
charge interest rates high enough to cover the cost of its loans. Otherwise,
the MFI will lose money. Its activities will shrink instead of growing unless
it is continually infused with fresh money from private donors or governments. The problem is
that donor and government money is not reliable, and there is not enough to
meet the demand. Commercial
investment fundings available, but MFIs must be sustainable, i.e., profitable
enough to continue, in order to attract this investment.
There are three kinds of costs the MFI has to cover when it
makes microloans. The first two, the cost of the
money that it lends and the cost of loan defaults, are proportional to the amount lent. For
instance, if the cost paid by the MFI for the money it lends is 10%, and it
experiences defaults of 1% of the amount lent, then these two costs will total
$11 for a loan of $100, and $55 for a loan of $500. An interest rate of 11% of
the loan amount thus covers both these costs for either loan.
The third type of cost, transaction costs, is not
proportional to the amount lent. The transaction cost of the $500 loan
is not much different from the transaction cost of the $100 loan. Both loans require roughly the same amount
of staff time for meeting with the borrower to appraise the loan, processing
the loan disbursement and repayments, and follow-up monitoring. Suppose that the transaction cost is $25 per loan and that
the loans are for one year. To break even on the $500 loan, the MFI would need
to collect interest of $50 + 5 + $25 = $80, which represents an annual interest
rate of 16%. To break even on the $100 loan, the MFI would need to
collect interest of $10 + 1 + $25 = $36, which is an interest rate of 36%. At first glance, a rate this high looks
abusive to many people, especially when the clients are poor. But in fact, this interest rate simply
reflects the basic reality that when loan sizes get very small, transaction
costs loom larger because these costs can‚t be cut below certain minimums.
Lending programs that continually
subsidize their borrowers will de-capitalize themselves unless they continue to
receive new subsidies from donors or governments. By contrast, MFIs who charge
their clients enough to cover all the loan costs can attract funding from
commercial sources and are capable of exponential growth without relying on
scarce and uncertain subsidies as funding sources.
MFIs have to charge rates that are higher than normal banking rates to keep the
service available, but even these rates are far below what poor people
routinely pay to village money-lenders and other informal sources, whose
percentage interest rates routinely rise into the hundreds and even the
thousands.
This does not mean that all high interest charges by MFIs
are justifiable. Sometimes MFIs, especially ones that are funded by donors, are
not aggressive enough in containing transaction costs.
The results is that they pass on unnecessarily high transaction costs to their
borrowers. Sustainability should be pursued by cutting costs as much as
possible, not just by raising interest rates to whatever the market will bear.
Ruth Goodwin-Groen, CGAP Donor Brief No. 6: Making
Sense of Microfinance Interest Rates
(Washington, D.C.: CGAP, September 2002).
Richard Rosenberg, "Calculating Effective Interest Rates," in
CGAP Occasional Paper No. 1: Microcredit Interest Rates
(Washington, D.C.: CGAP, Revised November 2002), 5-9.
Maria Otero
and Elisabeth Rhyne, eds.,
The New World of Microenterprise Finance:
Building Healthy Financial Institutions for the Poor, chapters 1, 5 (West Hartford, Conn.: Kumarian
Press, Inc., 1994).
D. Adams,
D. Graham, and J. von Pischke, eds.,
Undermining Rural Development with Cheap
Credit, part
B (Boulder,
Colo.: Westview Press, 1984).
L. Bennett and C. Cuevas,
"Sustainable Banking with the Poor,"
Journal of
International Development 8, no. 2 (1996): 145-52
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