Why Are Microfinance Interest Rates So High?
Why Are Microfinance Interest Rates So High?
In the few years since Muhammad Yunus won the Nobel Peace prize, microfinance has nearly become a household term. Donating to — and even investing in — microfinance organizations has become a popular year-end tradition for many philanthropically-minded families. But as people become more familiar with the microfinance industry, they ask the inevitable question: Why are the interest rates so high?
Indeed, microfinance interest rates do seem rather high when compared to commercial loan rates in the United States. At an average rate of around 30%, microfinance interest rates seem high even when compared to credit cards. But before you close your MicroPlace and Kiva accounts and discontinue your annual contribution to Accion, let’s dig deeper into this interest rate issue.
Some will argue that the added political and currency risks of lending abroad are what drive up rates to the micro borrower. While these factors certainly play a role, there are many pieces that play a part in the microfinance interest rate puzzle. To get a clearer picture of what’s going on, we should look at all the components that make up these rates.
Mixing it Up
Using statistics from the MIX Market — a microfinance industry association that collects financial information — we can look at the average figures for the components that make up microfinance interest rates.
According to the MIX, the average balance on a microloan across the 1,000 plus organizations that reported information in 2008 was around 0. The average nominal “yield on gross portfolio” was 30.7%. This portfolio yield is a close approximation of the average interest rate that microfinance institutions charge to their borrowers. Now a 30% interest rate may seem high, but how much profit are these institutions really making? To find out, we’ll need to take a closer look at their expenses.
The Cost of Financing
For the same group of microfinance institutions, the MIX reports that financial expenses constitute 5.2% of total assets, and their gross loan portfolios constitute 78.5% of total assets. We can use these two figures in combination to estimate 6.7 percentage points of the 30.7% total rate come from financial expenses.
So what does this mean? Microfinance institutions have to get the money they lend from somewhere. In many cases, they borrow funds from banks and microfinance investment vehicles (MIVs) — organizations that specialize in microfinance investment. Some microfinance institutions have their own depositor base from which they can lend capital. In any case, they must pay interest and origination fees on these borrowings. What our calculations above tell us is that the average cost of these funds is somewhere around 6.7%.
At first blush, 6.7% seems like a low rate given that these institutions are operating in developing countries with considerable political and market risks at play. But many of the people and organizations that finance these institutions are considered to be social investors. Social investors — such as government agencies, non-profits and other NGOs — are willing to accept a lower return on their money in exchange for the social mission that their investment fulfills. Hence, social investors help to lower the cost of borrowing money for microfinance institutions.
On top of financial expenses, financial institutions must accrue a loan loss reserve expense on any money they lend. Loan loss reserves help financial institutions to absorb future losses from bad loans. Using loan loss reserve statistics from the MIX and making our adjustment, we find that the loan loss reserve expense constitutes 1.4 percentage points of our microfinance interest rate.
Somebody’s Got to Do It
Once microfinance organizations have raised money, they have to lend it out, and to do so successfully can cost a bit of money. According to the MIX, administrative expenses — such as office space, information systems, transportation, etc. — constitute about 6.4% of a microfinance institution’s assets, which translates to 8.1 percentage points of the total rate when making our adjustment from above.
Microfinance institutions also have personnel expenses — salaries, benefits, etc. According to the MIX, personnel expenses were 8.0% of total assets, translating to 10.1 percentage points of our total 30.7% rate to borrowers.
Adding these two costs together we get total operating expenses of around 18.3 percentage points. Yes, administrative and personnel expenses are almost triple that of the borrowing cost. The spread that U.S. banks have to cover their operating expenses is usually only a couple hundred basis points (two percentage points) at most. Does this mean that microfinance institutions are highly inefficient and wasteful?
Well, yes and no. Yes, the business of microfinance by its very
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