Why are interest rates in microfinance so high?

 

The question of why are interest rates in microfinance so high often comes up in discussions with investors. That is why this special section provides a comprehensive analysis of interest rates in microfinance from the perspectives of two key stakeholders: (1) the microfinance institutions (MFI) and (2) the micro-entrepreneurs.

1. MFIs’ perspective

MFIs are social businesses and strive to operate in a financially sustainable manner. This implies that interest rates on microloans must cover all MFIs’ costs and include a reasonable profit margin. In LMDF’s case the average interest rate charged by a partner MFI is 29.6%, broken down into operating expenses (20.1%), re-financing costs (7.5%), provisions on non-performing loans (2.5%) and, on average, a small loss (-0.5%).

What stands out is that operating expenses are the largest determinant of the interest rate. One important reason is that business models of MFIs are based on proximity to their clients who operate mostly in the informal economy. Clients are often visited on a weekly basis. Second, MFIs of limited size need to amortize necessary fixed costs such as IT systems, management or branches over a large number of very small transactions.

2. Micro-entrepreneurs’ perspective

In poor areas, the lack of diversity of financial services and providers is critical. Frequently, disadvantaged resort to money lenders, much more expensive than microfinance in terms of interests charged  but they are accessible and do not require lengthy forms and loan documentation to be filled out. The persistence of the existence of moneylenders, even in environments where there is ample access to microfinance, illustrates the importance of a diversity of providers.

we should not forget the nature of the informal economy in which micro-entrepreneurs operate far from the standards and rules we know. The fact that even after paying back a microloan with a relatively “high” interest rate poor people are still able to make some money should imply that the rate of return on the cash they invested in their businesses is remarkably high. One often overlooked fact is that for most of these activities, the principal input is the time and skills of the micro-entrepreneur him/herself.

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