Why microfinance interest rates are high, and how to read them
Microloan interest rates are often far above bank rates, commonly 20% to 60% a year or more in effective terms. This is one of the most debated issues in the field.
What drives the price
The rate an MFI charges must cover four things:
- Cost of funds: what the MFI pays for deposits and borrowings.
- Loan-loss provisions: expected defaults.
- Operating costs: staff, visits, branches. This is usually the largest item, because loans are small.
- Profit or capital growth: to fund expansion.
Operating cost is the key. Lending $100 costs almost as much to administer as lending $1,000, so as a percentage of the loan it is far higher. CGAP research over many years has found that operating expenses, not profits, explain most of the difference in rates between MFIs.
Flat vs declining-balance rates
Many lenders quote a flat rate: interest calculated on the original amount for the whole term, even though the borrower repays principal in instalments.
Example. A $1,000 loan for 12 months at a “2% per month flat” rate charges $240 interest, with 12 payments of about $103.33. Because the balance falls each month, the effective rate is about 3.5% per month, or roughly 42% a year, not 24%.
Fees, upfront commissions and compulsory savings raise the effective cost further.
Transparency
Price-transparency campaigns found wide gaps between quoted and effective rates in several countries. Good practice, and many regulations, now require disclosure of an APR or effective interest rate that includes all fees, so clients can compare offers.
When are rates too high?
Rates are hard to justify when they are high because of inefficiency or excessive profit rather than genuine delivery cost. The 2007 Compartamos IPO, which revealed returns on equity above 50%, triggered a debate about this. Investors and analysts look at portfolio yield, operating expense ratio and ROE together to judge whether pricing is fair.