Are Microcredit Interest Rates Excessive?

Feb 2009
Washington, United States, February, 25 2009 - Are microfinance institutions (MFIs) exploiting poor borrowers by charging them excessive interest rates? Some think so. In 2007, for example, a controversy erupted around Compartamos, a Mexican MFI that was earning a 55 percent return on shareholders’ equity by charging its borrowers interest rates around 85 percent. The real question is, are high interest rates and profits like Compartamos’s outliers, or are they typical for a large number of MFIs?

Today, there’s widespread agreement that most MFIs should operate sustainably, keeping their costs as low as possible and charging interest rates and fees high enough to cover those costs. Making thousands of tiny loans entails higher administrative costs than making a few big loans, so sustainable MFIs must charge higher interest rates than normal banks do. But how much higher?

“There are huge variations in the interest rates and related circumstances of individual MFIs around the world,” says CGAP expert Rich Rosenberg. “There’s also intense debate about how high interest rates and profits would have to be to qualify as 'excessive,’ and indeed about whether terms like this have any useful meaning at all, at least in the arena of for-profit microfinance.”

While, there can be no one-size-fits-all answer to the question of whether microcredit rates are excessive, a new CGAP/MIX study of over 500 MFIs found data that shed important light on the issue.

Very high interest rate levels are the exception

The study found that the median interest rate for sustainable (i.e., profitable) MFIs was about 26 percent in 2006. The 85 percent interest rates charged by Compartamos were truly exceptional: less than 1 percent of borrowers pay rates that high. MFI interest rates also declined by 2.3 percentage points a year between 2003 and 2006, much faster than bank rates. What’s more, MFI rates were significantly lower than consumer and credit card rates in most of the 36 countries for which there were available rate indications; they were significantly higher than those rates in only a fifth of the countries according to the study. And MFIs charged less—usually vastly less—than informal lenders.

Interest rate factors in microfinance

Higher cost of funds

It’s a fact that MFIs have to pay more than banks do for borrowed money, and MFI managers don’t have much control over these costs, in the medium term at least.

Low default rates

While the cost of funds is necessarily reflected in MFI interest rates, rates are not being inflated by unreasonable loan losses. Default rates are very low—about 1.9 percent in 2006.

Higher administrative expenses

Tiny loans certainly require higher administrative expenses, which are not substantially offset by economies of scale. The good news is that the learning curve of MFIs as they age produces substantial cost reductions.

While we cannot quantify how much avoidable fat remains to be trimmed from MFI operating costs, one must expect substantial inefficiency when most MFIs are relatively young, and when few national microfinance markets are competitive. We know of no evidence to suggest that MFIs are out of line with the normal evolution of efficiency for businesses in such markets, and administrative costs have been declining by about a tenth per year since 2003.

Competition: A possible factor

One cannot assume that competition will always lower interest rates. But interest rates do appear to have dropped in the markets where microcredit has already become competitive, except for Bangladesh.

Profits are not the major determinant

The study found that profits are not a predominant driver of interest rates. For the median MFI, the imprudent scenario of complete elimination of all profit would cause its interest rate to drop by only about one-sixth. And MFI owners earn less on their investment than commercial bank owners in the first place. The median return on MFI equity in 2006 was moderate—12.3 percent, compared to 17.7 percent for banks. Profits of sustainable MFIs, measured as a percentage of loan portfolio, have in fact been dropping by about one-tenth (0.6 percentage points) per year since 2003.

When profits raise concern

At the same time, the most profitable tenth of the worldwide microcredit portfolio produced returns on equity above 34 percent in 2006—high enough to raise concerns about appropriateness for some observers. Much of this profit is captured by NGOs and never reaches private pockets. But some of it does go to private investors. Whether such profits are “abusive” would depend, not only on the observer’s standard for what a reasonable profit is, but also on individual MFIs’ circumstances, including the risk levels faced by investors when they committed their funds.

It’s hard to identify any widespread pattern of borrower exploitation

“How all this information is put together is up to each individual,” says Rosenberg. CGAP approaches the issue from a development perspective, where the main concern is not financial results but rather benefit for clients, including future clients. From that vantage point, a few MFIs have charged their borrowers interest rates that seem considerably higher than what would make sense. “Indeed, it would be astonishing if this were not the case, given the diversity of the industry and the scarcity of competitive markets yet.”

According to Rosenberg, “The real question is whether unreasonable rates are more than occasional exceptions. We don’t find evidence suggesting any widespread pattern of borrower exploitation by abusive MFI interest rates. We do find strong empirical evidence that operating costs are much higher for tiny microloans than for normal bank loans, so sustainable interest rates for microloans have to be significantly higher than normal bank interest rates. We also find that interest rates, operating costs, and profits have been declining quite rapidly in recent years, and we would expect this trend to continue in the medium-term future.”

Source : CGAP

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