In a paper published by Asian Development Bank (ADB), Nimal A. Fernando offers an explanation into why microcredit interest rates are so high, and what should, and should not be done to address this. The paper, entitled Understanding and Dealing with High Interest Rates on Microcredit, is addressed toward Asian Policymakers who have become increasingly critical of the high interest rates being charged by microfinance institutions (MFIs).
Interest charged on loans is the main source of income for MFIs. Thus they must be high enough to cover operational costs. Since microlending remains a high-cost operation, interest rates remain high. Mr. Fernando reports that MFIs in the Asia-Pacific region charge rates ranging from 30 to 70% a year. However, he goes on to say that it is important to remember that comparisons with rates charged by commercial banks are inappropriate. In that case, larger loans mean lower transaction costs and result in lower interest rates.
Still, there is much to be gained through lower microcredit interest rates. The current high costs mean microcredit efforts are not reaching as many people as they could be. According to Mr. Fernando, "Lower microcredit interest rates will help increase the depth and breadth of availability of affordable finance for poor households."Policymaker concern over high interest rates has led many to suggest capping interest rate by setting rate ceilings. Yet Mr. Fernando warns that this is not an appropriate solution, explaining "Rate ceilings will retard the growth of the MFI industry and result in reducing the supply of microcredit and other financial services, harming rather than helping poor and low income households." If rates are set to a level less than that required to cover costs, lenders will incur losses. Not only will this hurt MFIs’ ability to expand operations, but it will also reduce their creditworthiness and ability to borrow. Another danger here is that this would discourage potential investors from supporting the industry.
Instead, the paper concludes that the key to reducing interest rates is to reduce costs through improved market competition, innovation, and efficiency. Policymakers can play a role by improving financial infrastructure, promoting competition, and creating an enabling environment for MFIs. ADB was established in 1966 and is dedicated to reducing poverty in the Asia and Pacific region through sustainable economic growth, social development, and good governance. According to the 2005 Annual Report, $5.8 billion was issued for 72 loans for 64 projects. $198.7 million was spent on 299 technical assistance projects. As of year end 2004, ADB’s Microfinance Portfolio $510.69 million.
Additional Resources
1) ACN Newswire: ADB Paper Points to Key Factors to Reduce Interest Rates on Microcredit
2) Interest Rates and Self-Sufficiency by K. Stearns
3) CGAP Donor Brief No. 06: Making Sense of Microcredit Interest Rates
4) Microcapital Blog: further information on Interest Rates
