Why are microcredit interest rates higher than traditional interest rates?
A comparison between microcredit loans and traditional loans reveals several differences which affect interest rate levels. These differences are significant: the smaller size of the loans; the operational follow up required on the borrower and the fact that microcredit institutions have to pay to procure their own capital. They therefore represent two distinct economic models.
Smaller loans = higher interest rates
The operational costs on a large loan are practically identical to those on a smaller one. Result: these costs weigh heavier on the scale of a microcredit (on average 200 to 300 euros in emerging countries), than on that of a traditional loan (several thousand euros). It’s pure mathematics! A fixed cost of 10€ represents 10% of a 100€ loan and only 1% of a 1000€ loan. Therefore lending smaller amounts means a higher rate of interest.
Higher operating costs
On a day to day basis, microcredit agents are out in the field, sometimes in villages that are difficult to access, meeting lenders and following up on loan repayments. It is a time consuming job that is at the core of the microcredit business. As Alex Counts, President of the Fondation Grameen, says, “MFIs’ most important assets are not their loan portfolios, but their high-quality relationships with the world's poor.” (1)
This is very different from a credit manager in a traditional bank who firstly remains in his branch office and secondly evaluates risk based on the income declared in his entrepreneur client’s business plan.
Money costs the lender more
A minority of MFIs practice savings and deposits so efficiently that most microcredit institutions do not have their own resources and have to get most of their financing from local banks at ">rates varying between 8 and 20% (2). They also depend on financing from the North, which is rarely free of charge, whether in the form of preferential rate loans from the World Bank, philanthropic donations or loans from responsible investment funds. These funds prove, in any case, to be in the minority. In 2007, they only represented 25% of the total financing of microfinance instutions
Traditional banks do not have this problem; money loaned is a resource which is almost free of charge since it comes from their clients’ deposit and savings accounts.
The cost of unpaid debts and service charges
Unpaid debt and late repayments are very rare in microcredit, which is why the global cost of unpaid debts, which amounts to 3% on average, is no higher than for traditional loans. However, some microcredit institutions offer support services, such as campaigns to increase awareness of excess debt. This is one of the “added values” of microcredit, which represents a cost that is sometimes included in the interest rate charged on the microcredit.
The search for financial viability
To be sustainable, microfinance institutions must not only cover their costs, but also generate a reasonable profit. Those who manage to do this are rare: Out of 10,000 microcredit providers, only 150, according to the CGAP (3), are financially viable, with average interest rates of 26% (">CGAP figures)… Rates which Europeans find very high, even though they are well below money-lenders’ rates, which vary from 200% to 1000% per annum, and are sometimes even lower than credit card interest rates (in 36 countries from which reliable information could be gathered).
2 Microcrédit : comment faire baisser des taux d’intérêt trop élevés 15 Janvier 2007, Jérémy Hajdenberg co-auteur du guide du microcrédit
3Le guide de la microfinance. Microcrédit et épargne pour le développement, par Sébastien Boyé, Jérémy Hajdenberg et Christine Poursat Ed. d'Organisation, 2006, 304 p., 29 euros.