Declining balance interest rates better for microfinance borrowers
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Widespread adoption of the declining balance interest rate calculation method is better for microfinance borrowers, and the market as a whole. According to MFTransparency paper ‘Flat vs Declining Balance Interest Rates: What is the Difference?’, a borrower only pays interest on the actual money he or she has in hand at any given time, when interest is calculated using declining balance method.
Declining balance interest calculation method is based on the outstanding loan balance, the balance of money that remains in the borrower’s hands as the loan is repaid during the loan term. As the borrower repays installments, the remaining loan balance declines over time. Interest is then charged only on the loan amount that the borrower still holds. However the flat rate calculation method is widely used by micro lenders which charges interest on the full original loan amount throughout the loan term, rather than on the money that the borrower actually has in her hands.In Africa, about 70% of loan products include interest calculated using the flat rate method as compared to just 5% in Latin America.In Burkina Faso and India, the percentages are as high as 86% and 57% respectively. Prices calculated using flat interest payments sound much lower than those using declining balance interest rates.
It is an easy way for institutions to increase their income without giving clients the impression that their prices are more expensive. However, the declining balance calculation method is more transparent because the figure communicated to the client is closer to the figure representing the actual percentage of the loan amount paid in interest.
It is very difficult for borrowers to compare a loan with a 15% flat interest rate to a 25% declining balance rate. If all institutions used the same calculation method then borrowers would be able to make more informed decisions. This paper is the first in a new series of resources “MFTransparency Pricing Fundamentals”, available on MFTransparency’s website.