Transparent pricing in microfinance

Promoting Transparent Pricing in the Microfinance Industry Transparent Pricing in Microfinance

Which loan has the lowest price? Upfront Upfront Savings TotalOption Amount Term Interest Method Fees Savings Interest Cost 6Option 1 $1,000 3% declining 2% 0% 0% $125 months 4Option 2 $1,000 2% flat 2% 0% 0% $94 months 4Option 3 $1,000 3% declining 0% 20% 5% $56 monthsOption 4 All loans have the same APR.

Interest Rate Quiz - Answers Upfro Saving Poll Amoun Intere Upfron nt s TotalOption Term Method APR Result t st t Fees Savin Intere Cost s gs stOption 6 declinin 1 $1,000 months 3% g 2% 0% 0% $125 43% 22%Option 4 2 $1,000 months 2% flat 2% 0% 0% $94 57% 16%Option 4 declinin 3 $1,000 months 3% g 0% 20% 5% $56 54% 50%Option 4 All loans have the same APR. 12%

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 2.5% decl.  MFI 2: ◦ Interest: 3.0% decl.

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 2.5% decl. Some MFIs shift to flat interest  MFI 2: ◦ Interest: 2.0% flat

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 1.75% flat Some MFIs shift to flat interest  MFI 2: All MFIs shift to non- ◦ Interest: 2.0% flat transparent pricing

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 1.75% flat Some MFIs shift to flat interest  MFI 2: All MFIs shift to non- ◦ Interest: 1.6% flat, 2% upfront fee transparent pricing.. And it continues

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 1.75% flat Some MFIs shift to flat interest  MFI 2: All MFIs shift to non- ◦ Interest: 1.6% flat, 2% upfront fee transparent pricing Consumers struggle to choose…. Which would YOU choose?

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 1.75% flat Some MFIs shift to flat ◦ APR: 37% interest All MFIs shift to non-  MFI 2: transparent pricing ◦ Interest: 1.6% flat, 2% Consumers struggle to upfront fee choose… Because the ◦ APR: 57% prices are far from clear

The Downward Spiral All MFIs have  MFI 1: transparent prices ◦ Interest: 1.75% flat Some MFIs shift to flat ◦ APR: 37% interest ◦ ROE: 10% All MFIs shift to non- transparent pricing  MFI 2: Consumers struggle to ◦ Interest: 1.6% flat, 2% choose upfront fee Profits are correlated ◦ APR: 57% ◦ ROE: 40% to price

The Downward Spiral Prices are far from clear, and thus: ◦ Consumers over-consume ◦ Market competition is hindered ◦ Strong temptation from high profits ◦ The poor are harmed ◦ Public image is tarnished ◦ Governments urged to intervene Transparency, and particularly pricing transparency, is a key element to correct this serious problem in the microfinance industry

Example of Loan Pricing Interest rate of 3% per month Small closing fee of 2% Savings account with 15% of loan We pay you 5% interest on your savings What do you think the APR of this loan is? (we will calculate APR without compounding, i.e, using the US formula, not the EU formula)

Declining Balance interest reflects the textbook definition of interest as a charge for theuse of money over time. APR is equivalent to declining balance interest with no fees.

With “Flat” interest, interest is charged on the original loan amount resulting in nearlydouble the cost of declining balance interest. Why double? The area of the rectangleunder the green line is almost double the area under the red stair-step loan balance.

In addition, the client is often charged fees for the loan. In this example, a 2% up-front fee,because of the short loan term, surprisingly adds 13% to the APR. A loan advertised as 36%interest is now the equivalent of 78% APR.

The red area shows money invested in business. The blue line shows money held in savings.Compulsory savings adds to the cost. Clients are charged interest on the original loan ($1000)even though they never have use of that amount. In this example, the APR is now 107%.

Clients are paid interest, but significantly less interest on their savings than they are charged ontheir loans. When earning 5% interest, the APR only drops from 107% to 105%.

In this example, the client pays a total cost of $131 for the $1,000 loan for 16 weeks. If she wereto renew the loan consistently for an entire year, she would pay a total of $425 for the year.

Average net loan balance is $360But, the client never had a $1,000. She only received $850 because of the savings, andthen she paid back a portion each week. She paid $425 to have an average loan balanceof $360 for a year, giving an APR greater than 100%.

And with compulsory savings there are some months in which the client actually has moremoney in savings than invested in her business, giving a negative net loan balance.

Why has microfinance practiced and tolerated such universal non-transparency?• There is no “single interest rate” for microfinance products• MFIs have very different products and they need to be priced very differently• Difficult to communicate and educate the public about these issues• This is the major reason for non-transparent pricing in microfinance 23

Promoting Transparent Pricing in the Microfinance Industry

Transparent pricing in microfinance

by MicroFinance Transparency on May 24, 2011

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