What is Microfinance Loan?
Microfinance loan is a separate category in the banking industry which specifically caters to small scale industries and individuals who lack such financial framework where the amount credited is not very huge therefore obtaining the term microfinance, it is also one of the most emerging sectors today and many new Fintech Startups have come up with innovative products in their portfolio.
- A microloan is also called microcredit, but these two are quite different.
- Institutions that offer microloans also offer various products related to microfinance loans. For example, many financial companies offer micro-insurance, bank accounts, providing financial education, etc.
- These loans lie within the bracket of $100 and $25,000. The idea of microcredit is to offer self-sufficiency to people who are not financially stable.
Why are the interest rates for microfinance loans so high?
Before we dig in to understand why interest rates for microfinance loans are so high, we need to understand two things –
- Firstly, when the poor or unemployed people are given the microloan, the interest rate is not the number one concern for them. It’s because first of all, the interest rate is a simple interest rate. So no matter how high it becomes, it doesn’t concern them.
- Secondly, the microloan needs to be paid off within a short period of time, around 30 weeks. As a result, the interest rate doesn’t become a huge amount. For example, if $10,000 needs to be paid off within 20 years and the interest rate is around 30%; the interest would be havoc (i.e. $60,000 in simple interest). But if the duration is 30 weeks, the interest would be meager (i.e. $625 in simple interest).
Now let’s understand why the interest rates for microfinance loans are so high.
- The administrative costs for these loans are huge. And since the loans are given for a very short duration, the institutions try to cover the administrative costs with the interest rates. The administrative costs of these loans are around 10-15% of the loans. So if they don’t charge more interest rates, they wouldn’t be able to survive for a long time.
- There’s a huge risk in offering collateral-free loans. Even the established ones that are well off, lose around 1-2% of microfinance loans. The percentage may seem little, but if you think in terms of the total amount of loans, losing even 1-2% is huge Since there’s no guarantee whether the microfinance loans will be repaid back or not, the financial institutions charge more interest rates to compensate the possible losses.
- Fluctuation in currency and inflation are also the major causes for which the financial institutions lose their money. That’s why they keep the minimum (around 5-10% margin) operational profits. As a result, the fluctuation in currency and inflation doesn’t increase their losses.
What are Microfinance Institutions?
In simple terms, MFI stands for Microfinance Institutions. Most of the microfinance institutions are non-profits. But since there’s a huge need for funding in developing countries, remaining non-profits is not sustainable.
That’s why a new movement has started. The movement is about being for-profit. And being for-profit allows the institutions to reach to a large number of people and provide them with microfinance loans.
The challenge these for-profit organizations are facing is an imbalance between financial sustainability and the mission of serving the poor.
Even if it’s a challenge, many prominent global microfinance institutions have become for-profit organizations from non-profit institutions.
- For example, we can talk about the Grameen Bank. They created an extension of Grameen Bank, i.e. Grameen Foundation. And then the Grameen Bank has become a for-profit organization.
- Another example is the Compartamos Banco of Mexico. It has got enormous success by converting from non-profit to for-profit. But the approach of the bank has been severely criticized since they charge a whopping interest rate of up to 90%.
But all non-profits didn’t convert into for-profits. In this scenario, we can talk about the largest microfinance institution in the world, i.e. BRAC that still has been serving around 126 million people through its non-profit services.
Microfinance Institutions Risks
There are Microfinance Institutions risks even in serving people who are poor or unemployed.
The two possible risks are as follows –
- Firstly, there’s always a risk that the Microfinance Institutions won’t get back the money they’ve offered as microfinance loans. In the year 2008, a “no payment movement” shook the Microfinance Institutions in Nicaragua and as a result, the availability of microfinance loans in Nicaragua got reduced since then.
- Secondly, in developing countries like India, the cases of suicides have increased for not being able to pay off the microloan. Since the interest rates of these loans are huge and sometimes (if it’s not paid on time) they skyrocket, it becomes impossible for poor/farmers to pay off the loans.
For these risks, it’s not easy for Microfinance Institutions to remain non-profit and still offer microfinance loans to unemployed or poor people in developing countries.
Can Microfinance Institutions think differently?
Maintaining a balance between reaching out to the poor and unemployed in the developing countries and at the same time keeping the financial stability is a huge challenge.
Plus, there are huge risks of “no payment” and “suicides of farmers/poor” that make the job harder.
In this scenario, can these institutions think differently?
One of the bottlenecks of the Microfinance Institutions is the huge administrative costs. And since the administrative costs remain the same for a $100 loan or a $1000 loan, keeping a lower interest rate is still an afterthought.
So, what’s the solution?
Many experts suggest that it’s better to wipe off the interest rate altogether and just help the poor which will reduce the burden and rates of suicide will reduce. However, if the interest rate is nil, it would be impossible to maintain financial stability.
Other experts say that create factories and create jobs for people instead of just lending microfinance loans. That will keep the people in developing countries employed and at the same time the money the Microfinance Institutions are investing would be recouped through profits.
Creating jobs and factories is a great idea but Microfinance Institutions still have a huge risk in it. However, this solution seems to work out from all angles.
Creating jobs and factories will help Microfinance Institutions –
- Offer the same value to the poor
- There will be almost no bad debts
- There will be less administrative costs (infrastructural costs would be huge)
- The profits made from factories can be used for recouping the initial costs and the remaining can be reinvested in the factories again.
This has been a guide to what is Microfinance loans, its definition and why their interest rates are high. Additionally, we also discuss Microfinance Institutions (MFIs) and the risks that they face. You may also have a look at the following article to know more about Corporate Finance –