New Paper: The Challenge of Understanding Pricing of Micro-loans
Just how difficult is it to calculate the true cost of a loan? For many clients of MFIs, it is nearly impossible. Despite the public image of microfinance lenders as being altruistic and philanthropic, some are as predatory as the moneylenders they are supposed replace as a better alternative for their clients. With clients with a low level of financial literacy and a market lacking standardized pricing, many MFIs, including winners of responsible business awards, issue loans with actual costs orders of magnitude higher than advertised costs.
A new paper by MFTransparency CEO & President Chuck Waterfield called “The Challenge of Understanding Pricing of Micro-loans,” published in the new Resources section of this site, addresses this issue. The paper shows how the actual cost of a microfinance loan from the Mexican lender Compartamos is three times higher than the 4% per month rate advertised. Analyzing an actual 3,000 peso loan from Compartamos, the paper breaks down the contributing factors of the discrepancy between the advertised cost, a 48% APR, and actual cost, a 129% APR. These factors include:
- Having the “monthly” payments due every four weeks, instead of by calendar months
- Charging interest based on an outstanding balance never held
- Charging commissions and taxes
- Forcing the borrower to deposit a portion of the loan into a 0% interest savings account administered by the bank
For many customers of MFIs, what they are told about the cost of their loan is a gross understatement, and the path to revealing the true cost can be prohibitively complex. Unfortunately for borrowers of the loan product analyzed in the paper, it is likely well after signing the papers that they realize that they will be paying more in interest than in principal. Sadly, such complex structuring of microfinance loans is the industry standard in many countries. Even if some clients benefit from the use of such high-interest loans, transparency and standardization are still necessary to move the market towards more optimal conditions. MFTransparency strives to make the public aware of these practices and to help consumers understand the true cost of their loans. We hope that this paper will help the microfinance industry to mature to a healthier, more honest state.