How are microfinance institutions (MFIs), which charge interest rates of around 26% per annum, any better than moneylenders? If they aren’t, can MFIs learn from them and then better them?
One reason MFIs lend at these usurious rates is that the administrative costs are around 11.4% of outstanding loans. Moreover, MFIs generally lend for a tenor of less than one year. This translates into a higher interest rate in per annum terms. But this could easily not be the case if the costs were to be spread over the life of a longer-tenor loan.
This would be especially true for loans given against collateral: The recurring cost for such loans is mainly on account of managing the collateral—but this cost of (basically) storage and insurance is much lower than the one-time cost incurred while sanctioning the loan. Back-of-the-envelope calculations show that an approximately 6 percentage points drop in interest rates per annum would be possible by increasing the loan tenor from one year to four.
This change can greatly help the poor in their long-term finance needs in areas such as education and housing. And it is only reasonable to offer what financiers call a “moratorium” on educational loans backed by collateral—meaning the family doesn’t start paying back the loan until the child’s education is complete. After all, can one reasonably expect the poor to service educational loans even before they complete their education? Unfortunately, the microfinance models that exist today require not just paying interest, but also slowly paying back the principal through equated instalments, soon after the loan is disbursed.
MFIs do not offer such a moratorium to borrowers primarily because they generally lend without collateral. In the absence of collateral, it is frequent repayment that assures the lender. But that makes them lose out: It is time MFIs stop ceding the long-term lending space to moneylenders.
It is traditional moneylenders who, for centuries, have been addressing the poor’s finance needs. And they do get it right in some ways. In Rural Credit in Disarray, a 2008 book, Gautam Purkayastha says that in rural Assam, only 13.36% of all debt is contracted for a duration of one year or less. Around 67% of the moneylenders’ loans are for a minimum tenor of three years, that too with collateral.
Admittedly, there’s one potential problem with charging lower interest rates in per annum terms for longer-tenor loans: If the borrower ends up paying the loan before it is due. If the loan is prepaid, the high one-time administrative costs may not be recovered. One solution is for MFIs to charge a flat interest rate rather than an interest rate in per annum terms. So an MFI could charge a 100% (18.9% p.a. compounded annually) flat interest for a four-year bullet loan—with both principal and interest due at the end. This not only solves the prepayment problem, but also makes it possible for the borrower to maintain a moratorium until as late as the penultimate date for loan repayment—assuming the borrower has posted collateral. Interestingly, Hans-Dieter Roth’s Indian Moneylenders at Work (1983) notes that in Dhanbad, now in Jharkhand, certain types of loans have this kind of flat rate.
Not everything that the moneylenders do is wrong. Moneylenders are already addressing finance needs, but at the wrong price (interest rate). MFIs could learn from them and by applying economies of scale, provide long-term credit to the poor at lower rates. For this, though, we need an extensive nationwide survey on moneylending practices and possible collateral that the poor may be able to offer. Otherwise, any attempt to offer microcredit at reasonable interest rates is shooting in the dark.
A.M. Godbole is an adviser with AV Rajwade & Co. Pvt. Ltd, a risk management consulting firm. These are his personal views. Comment at firstname.lastname@example.org