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In most emerging countries, populations are growing and the numbers moving into cities are rising even faster. Providing housing for these often low-income individuals has become a momentous global challenge. This issue is driven in part by a lack of financing, which makes it difficult for these individuals to buy or build homes. Further complicating the picture, low-income families whose livelihoods come from the informal economy often have volatile incomes – and as analysts at Habitat for Humanity and CGAP point out, they lack the income proof and credit history required to be eligible for a mortgage loan.

Additionally, commercial lenders are reluctant to provide finance without collateral, which poorer borrowers cannot provide. They believe the perceived risks and costs of serving these borrowers outweigh the benefits. This problem is further exacerbated by ambiguous property rights and legal precedents that constrain conventional ways of financing housing. The complications associated with registering mortgages and gaining formal title to property – despite faulty land registries and multiple legal complexities – are major constraints.

As a result of all these obstacles, low-income households across emerging economies are denied access to stable housing, and are often forced to live in illegal slums or other informal housing. Yet traditional housing finance methods, such as mortgages and developer financing, have not been able to offer much help to people in this low-income group, as they are not designed to meet their needs.

The Promise of Housing Microfinance in Low-Income Communities

On the positive side, the free market – through housing microfinance – has shown promise to become part of the housing solution for low-income communities. A range of financial institutions are combining microfinance practices with traditional housing finance to make it more accessible for these populations. Successful housing microfinance providers have married the core principles of microcredit and the key tenets of group lending — e.g., peer-based borrower selection and repayment enforcement, close follow-up on repayment, etc. — with the technical expertise required to investigate land ownership, along with other classical housing finance principles.

Housing microfinance is broadly defined as small, non-mortgage-backed loans dedicated to housing activities, offered in sequences to support the incremental building practices common among low-income populations. These families typically can’t afford a large, long-term traditional mortgage to purchase a complete, developer-built unit, which forces them to build or renovate homes incrementally. Households save a little and then build a little. A series of small, short-term loans can fund the steps in this progressive housing process: acquiring a formal land title (or upgrading/regularizing the title to provide better protection against eviction), building a temporary shelter, replacing it with permanent materials and expanding it, and lobbying the government for utilities and other services. Housing microfinance meets those needs by offering a range of financial services that support homeowners’ efforts to improve their houses or properties, such as home repairs and expansions, the construction of additional cooking space, and the addition of water and sanitation services or a storefront to generate more income.

However, with this process, houses can take a long time to finish, are often shoddy, and suffer from severe quality and structural issues. And apart from financing, low-income households struggle to secure other housing inputs, such as materials, labor, home design, budgeting and reliable estimation. This results in either incomplete housing improvements or low-quality construction, which increases the lending risk for the microfinance institution (MFI). Clients may not be motivated enough to pay back loans if they aren’t happy with the house they’ve built, or if the home’s quality has deteriorated substantially through the life of the loan. To avoid this, some lenders try to improve borrowers’ homes by providing technical support in the construction process, such as sample plans or an engineer’s advice, to avoid cost overruns and incomplete construction. This also allows for houses that are safe, resilient and sustainable.

Typical Features of Housing Microfinance

Beyond these characteristics, housing microfinance typically involves the following features:

• Loans are for relatively small amounts and are based on clients’ capacity to repay.
• Repayment periods are relatively short (especially in comparison to mortgage lending) and are on par with mid-to-high-end individual loans in microfinance.
• Loan pricing is expected to cover the real, long-term costs – operational and financial – of providing the service.
• Loan repayment has flexible paying mechanisms based on variable income flows to increase demand.
• Loans are not heavily collateralized, if at all, and collateral substitutes – such as tax receipts or paralegal documents of land lease – are often used.
• A housing loan is combined with a small working capital loan to support economic activity – such combined loans are known as productive housing loans.
• Small, non-mortgage-backed loans are offered in succession to support the existing incremental building practices of low-income populations.
• Lenders aim for simplicity, flexibility and speed of disbursal, which are the primary factors in households’ decision to borrow. (Interest rates are also important, but secondary.)
• In many, though not all cases, housing investments directly generate additional income (e.g., through rentals or additional space for home-based microenterprise).

Challenges Facing Housing Microfinance in India

While formal land titles are not necessary for housing microfinance, land security is essential – and this is a key issue in India. Households are more likely to invest in their homes when they know they will not be evicted. This security is also important for financial institutions’ risk management. The housing microfinance model has been highly successful wherever governments are offering long-term tenancies. But the progress in offering these tenancies has been fairly slow, and the sector is still in need of more sustainable business models to increase its legitimacy in mainstream finance.

While housing microfinance has made tremendous headway in several countries, it has met with less success in India. There is no dearth of creative models in the country, and several experiments have been tried out – but their success rate is low. Some of these models appear attractive on paper, but they have yet to gain much traction on the ground. One of the major reasons for this failure is the high cost of these loans, which are unaffordable for low-income clients.

While traditional housing finance interest rates are around 8-9% in India, the interest cost of housing microfinance loans can be three times greater. This includes the actual borrowing costs plus mortgage and processing fees, insurance coverage, and other incidental expenses. There have been cases where homeowners have had to resort to selling off their newly constructed houses at a loss to pay off their housing microfinance loans. In the end, they were left not only without a house but with an additional loan from an informal lender that they had to use for paying the housing loan.

The focus of many Indian housing microfinance providers has been on generating huge returns with little regard to the implications on affordability for clients. Though they may justify this by arguing that their terms are better than informal lenders, this is not very convincing logic when the borrower is still paying an unaffordable interest rate. They’re also at a disadvantage compared to mainstream lenders, which are deposit-taking institutions that have access to low-cost funds that allow them to moderate their interest rates. This is not the case with housing microfinance, in which lenders have to mobilize equity and debt capital to cover the costs of their operations.

Social investors can play a key role in subsidizing these MFIs, to enable lower interest rates for housing loans. But microfinance can only become a reliable tool for affordable housing when loan providers moderate their appetite for financial returns. They can be very well compensated with rich social returns, but that will require sector leaders to clarify their mission: Do they want to serve the poor sustainably – or do they view these customers as a pathway to personal wealth? Much damage has already been caused to the sector in India, on account of the stark variance between MFIs’ public pronouncements of social mission and the lavish personal lifestyles of these lenders.

Better Approaches to Housing Lending in India

To avoid these issues and improve the sector’s social impact and reputation, lenders will need to adjust their approach. All microfinance practices are not necessarily suitable for housing loan products. For instance, one of the key features of India’s self-help group model of microfinance is the group loan product, in which shared loans provide capital for internal lending among the group, and the full group is responsible for paying off the loans. However, group loans have not worked well for housing finance, in part because the consequences of default extend to the entire group. These loans should ideally be individual loans backed by the guarantee of the group members.

Technology can also provide viable options for more effective housing microfinance. Generally speaking, banks have not lent to this segment because of the enormous acquisition costs. But digital payments can address these costs and open the floodgates to more bank lending to low-income borrowers. Digital technology has also made microfinance more nimble, and credit appraisal easier. The hope among sector stakeholders is that these platforms and digital innovations will enable traditional financial service providers, like banks and MFIs, to offer affordable housing-related loans at greater scale. But as other housing and financial inclusion analysts have pointed out, it’s still unclear if providers will pass any efficiency gains generated by digitization on to their customers through lower pricing or more inclusive lending criteria.

Whether it happens through innovative lending approaches or new technological tools, housing microlenders must adjust their business models to better suit the market – in India and other emerging countries. By tailoring their underwriting approach to the dynamics of these countries’ informal sectors and offering appropriate, accessible and fairly priced housing credit, they can create economic opportunities that would otherwise be inaccessible to these populations. And by using digital tools to circumvent cumbersome procedures and reduce incidental costs, they can make loans that are both affordable to customers and profitable to providers.

Reforms are also needed at each stage of the housing value chain, from securing the land title and engaging local communities, to building and improving homes that are safe, resilient and sustainable. A multi-stakeholder environment is needed, leveraging calls for action from all entities on all fronts – including local, state and federal government, the private sector, and civil society. The housing sector demands a high level of creativity, and there is a range of policy areas that can improve the functioning of different aspects of India’s housing system. However, the conventional bureaucratic approach and “business-as-usual” thinking will merely scratch the surface of the problem. And for any planned interventions to be successful, concrete timelines are required – and these timelines should be insulated from political turbulence.

The stresses of inadequate housing are mounting fast, and India needs to start talking very seriously about the elephant in the room – as do other emerging countries around the world. If lenders, government and other key stakeholders take effective, coordinated action, they can better navigate the pressures of population growth and provide the stable housing their people so urgently need.

Moin Qazi is an author and researcher who has spent four decades in the development sector.

Photo credit: R Barraez D´Lucca.