Americans often suffer sticker shock when they hear about interest rates charged in international microfinance. At annualized rates above 20 percent, most Americans start getting uncomfortable, and when they hear that in some places annual rates rise as high as 100 percent or even more, their moral outrage beepers start to malfunction. This is unfortunate, because when we are in a state of high outrage, it's hard to listen.
When asking "how much is too much?" it is important to reserve judgment long enough to examine the conditions that determine international microfinance interest rates. Here are three factors that international microfinance providers have to consider as they face the hard task of determining what constitutes responsible pricing.
The arithmetic of tiny loans. Interest rates face an uncompromising arithmetic of three main cost elements, all context-specific. How big are the loans? What is the maximum loan officer caseload? How much are loan officers paid? A lender making $1,000 loans in a dense city market with a labor market that allows modest loan officer salaries can charge a much lower interest rate (think Bolivia, with rates in the 20s) than a lender making $100 loans in the rural parts of a middle income country where loan officers earn a lot (think Mexico with rates in the 60s).
The need for sustainability to ensure coverage and permanence. Should prices support lender sustainability? Microfinance grew to reach 150 million clients worldwide by pursuing financial sustainability - and profitability -- as the ticket to reaching more people permanently without heavy donor dependence. Most of today's international microfinance providers believe the poor should be treated as clients, not recipients of charity.
This point does involve moral judgment. Is it more moral to help (a few of) the poor through subsidies or to provide (many of) them with services on a business basis? Answers may differ in different places. The wealthier United States may be able to afford to subsidize the less fortunate, while in the resource-strapped developing world, subsidies are a luxury not available to the masses of the excluded.
The needs and the existing options of the poor. Many people are surprised to learn that the poor in the developing world lead complex financial lives as they struggle to make their small, often intermittent incomes cover basic needs as well as unusual expenses and opportunities. Poor families are often both savers and borrowers, setting aside money in informal savings clubs, and borrowing from relatives, employers, and local grandees as well as professional moneylenders. While not all moneylenders by any means are the evil loan sharks of legend, they do generally charge rates far in excess of those charged by microlenders.
Still, it's fair to ask: can a microloan that tops out at a compound annual rate of say 80 percent inclusive of fees and taxes be a boon to poor borrowers? Client returns to investment are not well documented, but we do know that for short term loans, especially for the kinds of retail and restaurant businesses found in urban microfinance markets, opportunities to leverage an immediate lump sum of cash are often available. At an 80 percent APR, a microfinance client borrowing $500 for three months will pay back $600 - which many clients find to be an acceptable opportunity cost for equipment or stock that will boost a microenterprise's earning ability or for consumption needs such as school fees or home improvements.
That said, as interest rates come down and loan terms lengthen, microfinance loans become economically attractive to a wider range of businesses, and support longer term investments.
In countries such as Mexico where rates are high, market entrants and regulators need to do everything they can to bring rates down. Ultimately, the best means of doing so is to promote competition, which spurs the innovation that brings better products at lower prices.
The microfinance market in Bolivia provides a good example. In 1992 BancoSol, one of a few small microfinance loan providers at the time, charged an annual rate of 65 percent. Today, in a much more competitive environment, BancoSol and its direct competitors charge much lower rates, in the range of 18 to 22 percent. Worldwide, as microfinance has grown and many more providers have entered the market, a CGAP study found that average interest rates dropped by 2.3 percent per year from 2003 to 2006, with a median rate for profitable MFIs of about 26 percent.
Ultimately, responsible pricing makes good business sense. With the relatively high cost of acquiring new clients in microfinance, financial service providers survive based on long term customer relationships. Setting a price that allows the client's business to thrive helps to generate more future business for the financial institution.