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## Search form # Phnom Penh Post - 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