Calculating Transparent Prices in India – Overview of Methodology
What really is the true price of a loan? The true price of a loan takes into consideration pricing techniques that influence the amount of money a client actually has and the amount of time the client has use of that money. The true price of a loan includes not only interest paid on the loan but various other charges required by the lender to access a loan, such as compulsory fees, security or cash deposits and other charges. Because of these multiple factors, as well as differences in interest calculation methods, comparing the pricing of different loan products can be very challenging. The Annual Percentage Rate (APR) is a mathematical formula used to express the true price as a standard measure that allows for the comparison of credit charges among different loan products.
It is important to note that, generally speaking, all mandatory financial charges should be taken into account when calculating the true price of a loan product. In order to understand the true price of a loan, we must look at the cash flow of the client as she services the loan. Any requirement that reduces the amount of money available to the client during the loan cycle, regardless of its purpose, is considered a cost and should therefore be included in the calculation of the true price of the loan.
The Indian microfinance market is currently working to build consensus on standards of pricing, regulation and reporting. In the “Report of the Sub-Committee of the Central Board of Directors of Reserve Bank of India to Study Issues and Concerns in the MFI Sector” (also referred to as the “Malegam Report), a new set of industry standards for calculating the prices of microloans is established, contributing to those already commonly used. To reflect the various practices and standards currently used in India, the MFTransparency has dataset employs several variations of the APR formula. MFTransparency has chosen to display three commonly used Annualized Percentage Rate (APR) calculations in order to allow the viewer to compare the prices of microfinance products offered in India in a clear, consistent and accurate manner. These APR variations include:
1. APR India (Interest + Fees + Deposit):
As per the Microfinance Institutions Network (MFIN) Code of Conduct, member institutions calculate the APR of their products using the reducing balance method and must include most mandatory fees (i.e. processing fee, service charge, etc.) as well as mandatory security deposits collected upfront (also referred to as compulsory savings or cash security) or advance collection (or “upfront interest”). The APR India (Interest + Fees + Deposit) calculation does not, however, include any mandatory insurance charges levied on microloan.
2. APR (Interest + Fees + Insurance):
The international definition of an APR is the annual cost of a loan, including interest, the origination fee and mandatory insurance charges, expressed as a declining balance percentage rate. This rate does not include mandatory cash or security deposit (compulsory savings). This APR calculation is widely used in the global microfinance market as it accounts for many of the hidden costs charged to clients when accessing a loan.
3. APR (Including Security Deposit):
This rate is essentially the same as the internationally defined APR formula described in #2 (Interest + Fees + Insurance) but also includes mandatory security deposits described in #1. In effect, this rate is interest + fees + insurance + compulsory savings. MFTransparency advocates the use of this rate in addition to the others as it most accurately represents the true cost of a loan from the perspective of the client. By including all of the mandatory financial commitments a client assumes when accessing a loan, it comprehensively reflects the cash flow of a borrower when taking a microloan. The presentation of this rate, alongside the APR calculation described in APR India (Interest + Fees + Deposit), allows us to see exactly how much compulsory insurance charges really cost from the perspective of the client.
The Malegam Report recommends standardized interest rate calculations for all microfinance institutions. Their recommendation suggests “There should be only three components in the pricing of the loan, namely (i) a processing fee, not exceeding 1% of the gross loan amount (ii) the interest charge and (iii) the insurance premium.” (Malegam Report, Page 18) This disclosure of interest, mandatory fees and mandatory insurance premium is consistent with MFTransparency’s policies and is similar to the APR (Interest + Fees + Insurance) calculation we use globally. The unique feature of the Malegam interest rate calculation formula, and what sets it apart from the APR (Interest + Fees + Insurance) calculation, is the 1% ceiling placed on the processing fees. The formulas MFTransparency uses do not limit the components of interest rates but rather determine what components are required in disclosure. While the APR (Interest + Fees + Insurance) is representative of the Malegam Report’s recommended interest rate calculation, it includes all mandatory fees, which may include additional fees over the 1% processing fee the Reserve Bank of India will restrict MFIs to.
The following table provides a comparison of each of the interest rate formulas discussed above:
|APR India (Interest + Fees + Deposit)||X||X||X|
|APR (Interest + Fees + Insurance)||X||X||X|
|APR (Including Security Deposit)||X||X||X||X|
|Malegam Recommendation for Interest Rate Calculation||X||X*||X|
|*The Malegam Report recommends limiting fees to one loan processing fee of 1% of the gross loan amount. (Reserve Bank of India)|
It is our hope that the various rates we have calculated and displayed for MFTransparency’s Transparent Pricing Initiative in India will help MFIs, regulators and other industry stakeholders in India to work together towards defining a standard interest rate calculation and building consensus on reporting standards in order to be transparent and protect the rights of consumers. It is important to always consider the true price of a loan from the point-of-view of the client – how much money does a client have to spend in order to access a loan? It is only when we take into account the actual cash flow of the client that we can accurately understand how much a loan really costs. We believe that by considering the cost of borrowing from the client’s perspective all stakeholders in the industry can use the pricing data we have collected in India for the strengthening of the market as a whole.