Microcredit Interest Rates High Interest

Microcredit Interest Rates

High interest rates in microcredit

Microcredit and high interest rates: Explanations and proposals for reform

Microcredit and high interest rates: Explanations and proposals for reform

Microcredit involves the extension of very small loans to the very poorest members of society. Poor people have traditionally made use of unreliable and quasi-legal loan strategies such as loan sharks, borrowing from relatives, or pawn brokers. Thus the presence of commercial banks, credit unions, or NGOs that can function as more stable sources of available credit is a vital component of any poverty-reduction strategy. Access to microcredit enables individuals to engage in entrepreneurship activities that can enable them to extricate themselves from poverty, rather than merely accept charity. Targeted microcredit loans can also be used to empower disenfranchised members of the population, such as women.

Because of the poverty of the target population of microfinance, there is a high risk of nonpayment. However, microcredit has still been heavily criticized for its high interest rates. Microfinancers argue that such a cost is unavoidable: the cost of the money lent must be proportional the cost of loan defaults, which is frequent. "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" (About microfinance, 2009, Kiva).

Transaction costs are also extremely high in proportion to the amount loaned. Most microfinance 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," as large loans (About microfinance, 2009, Kiva). Additionally, small loans are not offset by economies of scale, especially for lending institutions in rural areas that process relatively few loans (Are microcredit interest rates excessive, 2009, CGAP). Reducing operational costs is thus a key element in making microcredit less usurious. Extending larger loans to a group of individuals, so the cost of the loan is dispersed to a community, rather than used to burden a single individual is another potential solution.

The charges of usury are also rooted in the highly variable rates of interest around the world of microfinance, which can create the perception of injustice. Furthermore, some loan rates are shocking, especially for loans extended by supposedly charitable institutions and programs: "in 2007, for example, a controversy erupted around Compartamos, a Mexican MFI that was earning a 55% return on shareholders' equity by charging its borrowers interest rates around 85%" (Are microcredit interest rates excessive, 2009, CGAP). On average, the median interest rate for profitable microfinance institutions (MFI)s was about 26% in 2006. While this is around the interest rate of some credit cards in the developed world, for individuals in poor rural areas it is still prohibitively high (and it is prohibitively high for many individuals in the developed world as well).