It’s the reasonable repayment plan-stupid!
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/>