Forbes India 15th Anniversary Special

The Interest Rate Myth In Indian Microfinance

There is no research supporting the idea that competition reduces rates charged by microfinance institutions in the industry. Even so, itís hard to find microfinance clients in India who are concerned about interest rates or even take it into consideration when deciding to take a loan

Published: Feb 9, 2011 06:20:41 AM IST
Updated: Feb 7, 2011 12:34:51 PM IST

When people hear on the news that microfinance institutions charge 25 percent, 30 percent or even 80 percent interest on loans, they often are outraged. How can these organizations get away with charging the poor these high rates, and why does no one regulate the industry? And most of all, why are the poor paying these exorbitant rates?

One of the biggest surprises to me during my three-week trip to India to study the microfinance industry is the fact that the interest rate on a microfinance loan is basically a nonissue for the poor.  When a poor person takes a loan from a microfinance institution, the interest rate is not the No. 1 or even a top 5 concern. Since the loan repayment cycle is so short, sometimes only 30 weeks, the interest rate does not have as much of an impact compared to a loan, for example, that is repaid over 20 years.  Also, the interest rate is a simple interest rate, so the impact on payments is not as dramatic as it would be on loans with compounding interest rates.

The borrowers are more concerned about getting enough capital to make a difference in their business, the repayment schedule (monthly vs. weekly), and the time commitment of the weekly repayment meetings. When compared to the interest rates charged by village moneylenders (100 percent, 200 percent or even 1,000 percent), the rates, the non-coercive nature, and the insurance benefits of the microfinance institutions seem even more reasonable.

Currently in India, microfinance institutions face the threat of intense regulation from the government.  Up until now, the government has mostly stayed out of regulating the microfinance industry.  But presently with increasing issues with multiple lending, suicide, and reports of exploitation, the government is determined to step in and regulate the industry.

Some industry experts say the government is only getting involved to win votes, but regardless of the motive, the government has the power to dramatically reshape the entire industry of microfinance in India. The first step has been to cap the interest rate at 24 percent. Although this law is not strictly enforced yet, it shows how much the government in India does not understand the microfinance industry.

Microfinance institutions serve a unique client base that does not have access to traditional banking services. The reason why these clients do not have access is because they live in remote villages that are expensive to reach and previously thought not to have the resources or collateral necessary for traditional banking. From my experience visiting rural clients for microfinance institutions in India, it can take several hours of travel in order to reach these clients.  With weekly collection meetings, loan officers are constantly traveling from village to village, spending increasingly high amounts of money on fuel and vehicle maintenance from tough village roads, to collect only hundreds of dollars each day. The cost per transaction is high because despite the high volume of transactions each day, the amounts collected are minimal compared to traditional banks.

The reason why the interest rates are so high is because microfinance institutions borrow from banks with interest rates that range from 12 percent to 15 percent, then spend about 10 percent on high costs, 5 percent to protect against high risk of default, 2 percent to 5 percent for supplemental support products such as insurance, and 5 percent to 10 percent for returns for investors.

Most microfinance institutions in India need to use private equity to raise capital because they are not allowed to collect savings, like traditional banks, as a way to fund loans; therefore, the microfinance institutions have a duty to provide their investors with an adequate return on investment. Capping interest rates at 24 percent could destroy the microfinance industry in India.

Some microfinance institutions have taken advantage of the scale of their large operations and could survive at a rate of 24 percent, but most institutions, especially those that serve the poorest of the poor and focus on social impact, could not survive. The industry does need some regulation to protect the clients from institutions that drift from their original social mission. But capping the interest rate will put the industry into crisis, or at least cut services to those that need it most — the clients in remote villages that are the most expensive to access.

[This article has been reproduced with permission from Knowledge Network, the online thought leadership platform for Thunderbird School of Global Management]