Interest Rates

Interest rates charged for lending are a function of a number of factors, of those, transaction costs and risk figure prominently into the derivation of lending interest rates. Smalll Lenders (Microfinancier) are subject to significantly higher transaction costs than banks.

There are three types of costs that is associated with the lending process: the cost of funds for on-lending; the cost of risk (loan loss); and administrative costs (identifying and screening clients, processing loan applications, disbursing payments, collecting repayments, and following up on non-repayment).

The costs of capital and loan loss risk vary proportionally with loan size. Both Big and Small Lenders need to raise US $1,000,000 to fund their loans and will have to pay the same market rate - say, 10 percent - for the money. If both lenders have a history of losing 1 percent of their loans to default each year, they will need a loan loss provision of that amount. Both lenders can cover the cost of their capital and their risk by charging 11 percent (10% + 1% = 11%) on the loans they make to their customers.

Finance Administrative costs are not proportional to loan size. Making a single loan of US $1,000,000 might cost Big Lender US $30,000 (3 percent of the loan amount) in staff time and other expenses involved in appraising, disbursing, monitoring, and collecting the loan. Big Lender can cover all its costs by charging the borrower an interest rate of 14 percent (10% + 1% + 3% = 14%).

However, Small Lender's administrative costs for each US $10,000 loan will be much higher than 3 percent of the loan amount. Small Lender is more likely to have to spend more per borrower. Big Lender has to deal with only a single borrower, but Small Lender has to deal with 1,000 borrowers who typically do not have collateral, financial statements, or records in the database of a credit reporting bureau. Many of these clients may be illiterate. Lending to, and collecting from, such clients, requires time-consuming personal interaction.

Due to the higher number of transaction per loan, to cover such cost will requires a 20 percent charge on loaned amounts, resulting in an interest rate of at least 33 percent (10% + 1% + 20% = 33%)

At this point, it is important to keep in mind that despite these high interest rates, micro-loans still provide positive marginal benefits for borrowers. Moreover, the potential to increase these benefits exists as the infrastructure of the industry grows, lowering costs.

Updated On: 09.10.04