Microcredit Interest Rates

This paper presents ways to set sustainable interest rates, and demonstrates how effective interest rates can be raised. Sustainable interest rates are set as a function of five elements, each expressed as a percentage of average outstanding loan portfolio. They are administrative expenses, loan losses, cost of funds, desired capitalization rate, and investment income.

The paper states that MFIs should charge clients a rate high enough to ensure their own sustainability rather than deliver subsidized credit. Methods to raise the effective interest rates include:

• Computing interest on the original face value of the loan, rather than on the declining balance, as successive installments of principal are repaid;
• Requiring payment of interest at the beginning of the loan, rather than spreading interest payments throughout the life of the loan;
• Charging a commission or fee in addition to the interest;
• Quoting a monthly interest rate, but collecting principal and interest weekly, counting four weeks as a month;
• Requiring that a portion of the loan amount be deposited with the lender as compulsory savings or a compensating balance.

Also available in French, Spanish, Arabic, Russian, and Bahasa here.