Why Microfinance Loans Have Such High Rates

Wednesday, August 12, 2015

In recent years, microfinance—distributing small loans to the poor — has been at the center of an intense debate about the ethics of charging low-income customers high interest rates and then making a profit from them.

Chuck Waterfield created a microfinance institution in Haiti in 1985 followed by one in Bolivia and has since worked with microfinance providers including in Peru and Mexico. In 2008, he founded Micro-Finance Transparency, a U.S.-based nonprofit that analyzes interest rates, fees and regulatory issues involving microfinancing institutions around the world.

The 57-year-old American, one of the judges for The Wall Street Journal’s Financial Inclusion Challenge, spoke to the Journal about some of the common misconceptions about microfinance interest rates, how microloan prices are set, and the ethics of making profit from the poor. Edited excerpts from the interview:

Why are microfinance interest rates usually higher than commercial bank rates?

Microfinance uses a labor-intensive method of disbursing loans, with loan officers going out and visiting clients face to face in rural areas, villages or slums on a regular basis. This is far more expensive than customers going to bank branches. Lenders have worked at improving efficiencies, such as grouping clients together for visits and reducing the amount of training that is bundled with the loan. But even so, operational costs are relatively higher than for conventional loans.

To give an example, if the lender spends $100 to manage a $1000 loan for a year, that 10% operating cost ratio needs to be built into the price—which includes the interest rate plus any fees. If the loans are smaller and you spend $100 to manage a $200 loan, then you’re at 50%.

How can a poor borrower pay back a microloan with a 30% interest rate, much less a 100% one? Isn’t this extortion that’s not much better than going to a loan shark?

Borrowers can and do pay back because a high price on a small loan is within their means. If the total debt of the client doesn’t get too high, they can pay it off, but there are serious doubts about the client being better off after paying all that interest. In borrowing for their microbusiness, clients potentially can invest that $200, make a quick return to cover the cost of the loan, and be better off.

Source: The Wall Street Journal (link opens in a new window)

lending, microfinance