Calculating Effective Interest Rates on Microcredit Loans

This article is available on pages 39-43 of this compilation document.

The paper states that a microcredit interest rate quoted at 3% per month may be equivalent to a much higher effective rate, depending on how the loan and its repayment are structured. The real cost to the borrower, and the real income generated by the lending institution's loan portfolio, can be raised significantly by refining computing practices.

The paper explains how to compute effective interest rates on loans with combinations of various features. The effective interest rate of a particular loan contract is the rate which a client is 'really' paying during each period of the life of the loan. The paper conclusively suggests six possible way of calculating interest rates:

• Up-front interest payments where all interest is charged at the beginning of the loan;
• Initial fee where a 3% loan commission is charged up front;
• Weekly payments where four months' worth of payments are paid in sixteen weekly instalments;
• Flat interest, calculated on the entire loan amount, rather than on declining balances, and pro-rated over the four monthly payments;
• Flat with up front interest, interest calculated each period on entire loan amount - except that all the interest is paid up front at the beginning of the loan;
• Flat with up-front fee and interest, flat interest is charged on entire loan amount; total interest plus a 3% commission collected up front at the time of loan disbursement.