Microfinance Loans: A Risky Business?

By Tanner Schoenike

            Everyone knows the age-old concept of a loan, someone (usually a bank) will give somebody else some money, in order to buy something, or invest in something that will increase their income or enjoyment over the long run, and the banks will do this because of interest rates, the concept that the longer the money takes to repay, the more that the person will end up having to repay. One of these normal loans could have an interest rate anywhere from around 2% to upwards of 6% or 7% compounded interest, per year. ¹

            But, other than these normal, everyday loans, comes the idea of microfinance loans, incredibly small loans, with incredibly high interest rates. These loans are used primarily in poorer countries, like those in Africa or the Middle East. And, the purpose of these can be used for small investments (by our standards) to buy something like an ox, a pig, a cart, a solar panel, or a seed press. The idea is very similar to that of marginal utility, the first of a product will provide a lot of extra utility to a person; and for a very poor person, a single ox could provide milk, the ability to plow a field, and the ability to pull a cart of goods to market. ²

            The essential idea is that for very poor people, a small loan could potentially drastically increase their income. But, the idea of microloans requires the bank to spread out a fair amount of money over a lot of people, and the more people they service, the harder it is to keep track of the people, the harder it is to collect debts and such. And, by the fact that they are very poor, if they buy an ox with a loan in order to increase their income, but then the ox dies a week after they get it; they are left with no way to pay back the loan, so it becomes a very risky business for bankers. So, in order to compensate for the risks they take, they drastically increase the interest rates on loans, as high as 70% interest per year, and with an average interest rate of above 30%.³

           However solid this thought train works in concept, the truth remains quite different, as through several studies, it has been shown that microloans are repaid in much higher rates, and much more consistently than loans in the US, despite the higher interest rates. The microloans issued from one of the largest microcredit institutions, Grameen Bank, were examined for their delinquency rates – what is essentially the rate at which the loans are repaid properly – and found to be anywhere from less than 1% delinquency to nearly 3.5% delinquency, while the US loans – ranging in areas from residential to credit cards to agricultural loans – were found to have delinquency rates as low as 1%, but also having rates over 10%. ⁴⁵

            The consistency with which the rates are repaid in poorer countries, by poorer people is still far superior to that of people in the US; even though they have much higher interest rates. So, the reasoning for which microloans are compounding interest at a much higher rate is not sound, in fact, the reasoning should point to higher interest rates for normal, US-bound loans. Microcredit is not a risky business; it is a safer business than US credit.

1:http://www.mortgagecalculator.org/mortgage-rates/

2:http://www.kiva.org/about/microfinance

3:http://www.nytimes.com/2010/04/14/world/14microfinance.html?pagewanted=all&_r=0

4:http://investing.curiouscatblog.net/wp-content/uploads/2010/04/loan_delinquency_rates_1998-2009.png

5:http://www.cgdev.org/doc/blog/Roodman%20open%20book/Delinquency%20indicators,%20Grameen%20Bank,%202002-.png