Microfinance Interest Rates

Interest rates. The assigned readings as well as the video we saw on Muhammad Yunus really gave us no information about what rates the borrowers were charged. We know that the loans are for relatively small amounts of money, but what kind of return are the lenders getting? In theory, a bank/lender that is dispensing and managing 1,000 loans of $100 each will have considerably more overhead than a bank/lender of one $100,000 loan. 1,000 loans, regardless of their amount, would just require more work than one loan (CGAP explains this in greater detail). So how does this manifest itself?

In short, microfinance institutions (MFIs) have high interest rates. According to CGAP (Consultative Group to Assist the Poor), the average MFI interest rate was around 28 percent in 2006. Muhammad Yunus Grameen Bank lists their interest rate for all loans at 16 percent. While these rates seem high compared to what we're used to encountering for loans in the U.S., they are a reflection of the added overhead costs with microlending. Moreover, CGAP says that MFI loans have interest rates that are lower than both consumer and credit card rates in the borrowers' countries. The loan rates are also considerably less than local, informal money lenders. Many sources say these lenders charge borrowers upwards of 300 percent. So, given the alternatives, the interest rates on MFI loans seem to be entirely fair and reasonable for the borrowers in those markets. But has anyone been able to lower those overhead costs and effectively "frugal engineer" the microlending process?

In researching this topic I came across a lending organization called Kiva (Raymar also mentioned them in his last post). My initial impression from their website, as well as this Frontline piece, was that donors make contributions through the website that become microloans for the borrowers. Once the loan is repaid, the donors get their money back with no interest. I presumed that Kiva would then either charge a small "finder's fee" or use other donations to cover their business expenses. This model would conceivably be able to lower the costs of microlending. However, in reality Kiva acts as more of a go-between.

Here is how Kiva's loan process actually works (explained here on their website). A local MFI, or Field Partner, loans the money to the borrower first and the funds from Kiva are given to the lender later. This money only covers the principal amount. Since the MFIs are still responsible for administering the loan (e.g. collecting payments), they are able to charge interest on the principal amount. Kiva's Field Partners appear to charge rates to the borrowers that are comparable to those in their countries (each Field Partner's link lists the interest rate at the bottom of their page). In this sense, the funds from Kiva act more as collateral than a direct loan. The risk of lending is then spread out over the Kiva donors instead of being assumed by the MFI. Some of the Field Partner's reflect this reduction in risk by charging the borrowers lower interest rates or offering interest refunds once the loan has been repaid. So while they are not creating a dramatic shift in the microlending process, Kiva is able to expand and, in some instances, improve the service.

Even though the MFIs are charging interest rates that are lower than the local alternatives, I still wonder what could be done to bring down the costs. Will it happen because of a technological innovation? If mainstream financial institutions enter the microlending market, will they lower the costs? Will the rates be lowered by some combination of the two? Or are the rates already more than fair?

Let me know what you think.

Thanks,

-Kyle