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Micro-finance interest rates

Micro-finance interest rates

Dear Editor,

Thank you for Caroline Green's article dealing with some of the serious problems

of micro-finance.

One aspect that requires further explanation is the understating of annual interest

rates that occurs when rates are quoted per month. A loan at interest of 5% a month

is not equivalent to an annual rate of 60% if the loan is repaid in monthly installments.

If I borrow $120 for a year at 60%, at the end of the year I return the $120, plus

60% x $120 = $72. I have bought the use of $120 for a year, at a cost of $72.

But if I borrow according to the "balloon approach" described in the article,

I am required to pay 5% of $120, or $6, at the end of each month, and to pay $120

at the end of the year. This is clearly more disadvantageous to me, because the cost

of the loan is still $72, but I do not obtain the use of $120 for a full year.

To find the real annual interest rate in this case, we need to regard the $6 monthly

payments as repayments of the principal. Then the final payment of $120 consists

of two elements: $72 in interest and the remaining $48 of the principal that has

not yet been repaid.

In this example, I have obtained, not the use of $120 for a year, but the use

of $120 in the first month, the use of $114 in the second month, the use of $108

in the third month, and so on down to only $54 in the twelfth month. Thus the real

amount of my loan during the year is not $120, but the average of the 12 monthly

figures, which comes to $87. Since I have paid $72 to obtain $87 for a year, my interest

rate is 72 divided by 87, or slightly less than 83%.

If the total repayment ($120 + $72) is made in equal monthly installments of $16,

the annual interest rate is of course even higher. In this case, the borrower obtains

the use of an average of only $32 for the year and pays interest of $72, so the interest

rate is 225%. Even if the so-called monthly rate is reduced to 3%, a loan repaid

in this way has an annual interest rate of 95.6%.

- Allen Myers, Phnom Penh


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