Are Microcredit Interest Rates Exploitative?

An interview with CGAP expert Rich Rosenberg

June 17, 2008

An interview with CGAP microfinance expert Rich Rosenberg

The last few years have seen increasing criticism of microcredit interest rates. Many people feel it is unfair to charge poor people rates that are a lot higher than those that wealthy people pay on bigger loans. In the context of some sensational headlines around the issue, we asked CGAP microfinance expert Rich Rosenberg to give us some more background on the issue.

1. To begin with, how high are microcredit interest rates?
When the Mexican MFI Compartamos sold shares to the public last year, there was an outcry about its interest rates, which were above 100 percent a year for a while. Some people got the mistaken impression that such rates were typical for microcredit. In fact, the median interest rate for the 700 MFIs in the Mix Market database for 2006 was 30 percent (22 percent net of inflation).

2. What's the trend—are rates moving up or down?
Actually, it's surprising how fast microcredit rates have been dropping—3.3 percentage points per year from 2000 to 2005. I'd guess that most of this drop is a reflection of the learning curve as new MFIs figure out how to squeeze down their operating costs. But some of it is because of competition, which has been heating up in the countries where the industry is most advanced. Competition will certainly get more intense over the next decade, exerting more downward pressure on rates.

3. Are the rates unreasonable? Are poor borrowers being gouged?
That's the most important question, isn't it? Obviously, we can't expect a one-size-fits-all answer: it would depend on a detailed analysis of each MFI, its market, and its borrowers. CGAP argued in a recent paper [CGAP Reflections on the Compartamos Initial Public Offering] that the Compartamos interest rate has been a lot higher than it should have been, but that's an exceptional case. The picture differs widely by institution, and by country, but I think we can shed some useful light on the overall situation (CGAP will soon be publishing a study of the issue in a forthcoming Focus Note.)
One approach is to compare MFI interest rates in a country to the rates on other kinds of small loans that lower income people use. The idea is that making lots of small loans will inevitably cost more than making a few big loans, so what kind of rates are charged by other small lenders? Where we've been able to get data, it appears that MFIs almost always charge far less than informal moneylenders. They're in roughly the same ballpark as rates on credit cards and other consumption credit. MFIs tend to charge more than credit unions, though we find that MFIs with banking licenses charge less than credit unions on average.
The most powerful approach to the question of whether interest charges are too high is to look at the individual cost items that those charges cover (cost of funds, loan losses, and administrative costs) and the profit that's left over after paying the costs.
MFIs borrow much of the money they lend out, and the interest they pay on these borrowed funds ties up about a quarter of their interest income from their clients. It doesn't seem too useful to argue about whether these funding costs are too high, because MFI managers usually have little control over what their outside funding sources charge, in the near term at least.
Managers have a lot of control over loan losses, but in good MFIs these are only a tiny factor, about 1-1.5 percent.

4. It sounds OK so far, but what about profits?
Few MFIs make really high profits: the median inflation-adjusted return on loan portfolio for MFIs worldwide was 1.1 percent in 2006. MFI profits are much lower than what one would typically see in an emerging industry, before competition sets in—so much so that very few MFIs are attractive investment targets for commercial, profit-maximizing investors.
It's important to note that profit is a fairly small piece of interest income. Let's take an MFI that is charging its clients 30 percent interest and making a profit of 4 percent on portfolio (four times the median). If it cuts its profit back to only 1 percent, it still has to charge clients 27 percent.
The big factor is not profit but administrative costs. The administrative cost of managing tiny loans eats up roughly two-thirds of the interest clients pay. It's not easy to get a statistical handle on whether these costs are "too high." Figuring out whether an MFI can cut its administrative costs without hurting the quality of its service requires detailed analysis of an individual MFI's circumstances and clientele. In general terms, we can be sure that there is room for more efficiency, because microcredit is still a relatively immature industry in most countries. Costs are always higher in immature industries. Those industries get more efficient over time, based on their own internal learning curve as well as the pressure of competition. Of course, we would all like to see efficiency improve as fast as possible, but it's unrealistic to expect that to happen overnight.

5. So what's the answer? Are microcredit interest rates unreasonably high?

Let's say that rates are "unreasonable" if MFI managers could be charging clients substantially less, even after taking into account the small sizes of the loans and the inevitable learning curve of institutions and national microfinance industries. We don't have enough data to provide a conclusive answer to that question. But based on a reading of the data we do have, I'll hazard an impression: I think there are a few MFIs out there charging unreasonable rates, but only a few. I think a vast majority of microcredit borrowers are paying rates that are pretty fair in light of the loan sizes and the early stage of the industry in most countries.

6. What should governments be doing about microcredit interest rates?
People who are shocked by microcredit rates that strike them as exploitative often want the government to impose interest rate caps. CGAP continues to think that the effect of such caps would usually be to limit poor people's access to credit. When a government body sets a maximum rate, it is politically difficult to set it high enough to cover the inevitable extra cost of making tiny loans. If microlenders can't charge enough to cover those costs, they are less likely to continue or expand services. We think it may be more useful to look at other consumer protection measures, like requiring clear disclosure of loan costs. Early evidence supports the proposition that increasing competition, along with the learning curve, will continue to push interest rates lower and efficiency higher