Why Micro-finance is More Expensive

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Seattle — Since the concept of microfinance was first born in 1974, small-scale loans have evolved into a widely accepted tool for poverty alleviation. Organizations, such as Kiva and the Grameen Foundation, allow people to provide loans to poor individuals or low-income communities in areas without a traditional banking structure.

Microfinance Institutions and the people who lend through them have become increasingly common, and this, in part, has made small loans more expensive. Global loans through microfinance grew by 30 percent each year between 2004 and 2011, as stated in a report from data provider MIX Market. One year after the United Nations called 2005 the year of Microcredit, the World Bank estimated that there were over 7,000 micro-finance institutions across the globe.

In that same time period, data from a recent study of more than 1,500 micro-finance institutions revealed that interests on small scale loans of less than $150 increased from 30 percent to 35 percent. Microfinance loans are already more expensive to process than large loans because they take longer to determine borrower creditworthiness and necessitate a more thorough, hands on examination.

However, the increase in microfinance loans around the globe has simultaneously heightened competition. This growth in turn has made interested lenders more confident, explained William Ford of MIX in The Economist.

As a growing number of people fund small scale loans, banks in turn have begun to serve risky, lower-income borrowers they might not have before. Mid-market microfinance institutions realized, with the increased competition in mind, that they could reasonably lend to the poorest borrower, and lower end microfinance banks began lending to borrowers that they might have previously dubbed as too risky.

With riskier loans being made, defaults have become more frequent and interest rates have risen. The substantial expansion of the micro-finance market has increased the basic funding costs for micro-finance institutions in order to keep up with the industry’s growth. Funding costs for low end microfinance groups grew by 70 percent between 2004 and 2011.

“We have made an assumption in microfinance that profitability is not at odds with having an impact, but in many cases it has to be,” said Yale faculty member Rodrigo Canales in a Yale Insights discussion. “In many places it’s very expensive to provide microcredit, so the interest rates that you have to charge in order to get the sustainable machine going end up negating a lot of the reasons why you even started doing it in the first place.”

Microfinance loans must be evaluated carefully and weighed with impact in mind.

Today, the sector is widely debated by scholars and economists on whether or not it is successful in reducing poverty. Some argue that the world’s poorest, who need loans most, often don’t qualify for loans because of the associated risk, and those who do quality do not use it for the originally stated purposes.

Still, the microfinance model is widely accepted and continually used around the globe. Increasing interest rates on small loans are an issue that must be evaluated by particular institutions as this method of developing country investment evolves forward.

Julia Thomas

Sources: The Economist, Microfinance Gateway, Yale Insights, PBS
Photo: PBS

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