Financial services for next billion? [Part 5] The price of money

Similar to my last 4 posts in my series on “financial services for next billion?”, in this one I have covered chapter 5 of the book – Portfolios of the poor in Q&A format, covering pieces around how poor people create and manage the large sums of money.

Why micro-finance rates are so high?
“those institutions serving the poorest face the highest cost of lending. Finance for the poor means dealing with lots of small loans and, when saving services are on offer, many small deposits. For providers, small sized transactions mean limited scale economies and thus high cost per transaction. Out of necessity, “pro-poor” micro-finance institutions tend to charge the highest interest rates of all; micro-finance banks serving better off customers tend to charge the least.”

Does micro-finance charge as high as local moneylenders?
“Interest rates this high sound usurious, perhaps, but borrowers report that local moneylenders, who charge much more, will only lend them much smaller amounts of money.”

Are poor people ready to pay high prices?
“In general, we find that households are willing to pay prices that are high when compared to those routinely paid by the better off. Some economists have attempted to explain the poor’s capacity to pay high prices by noting the high return on capital found in micro-businesses.”
“poor households are insensitive to price, but then nothing suggests that price is the overriding concern when they seek financial services.”

Source: Portfolios of the Poor

Why rates are high?
” It is easy to assume that the main reason behind high interest rates is the risk of doing business with low-income people. But there are several other reasons why the price of the money is high: the short term nature of lending, the relatively small size of the principal, the lack of compounding interest, and the flexibility of arrangements. Not only is prince only part of the picture, but price adjusts to many other factors.”

Is putting price cap is detrimental to the industry?
“Pricing is not a simple and transparent matter, and prices actually paid often differ from stated prices. On balance, our findings tend to support the view that legislation restricting interest rates would be counterproductive for pro-poor providers. Price caps would undermine the work of institutions like SEF that fill gaps and open opportunities for households with limited financial options.”

Is it fee for a service or an interest rate?
“An immediate insight is that interest rates may often be better understood as fees for a service than as a rate for the use of money for a specific period.”
“Seeing interest rates as a fee rather than an interest rate goes some way to helping us understand why households are sometimes happy to pay what we might consider to be astronomically high interest rates.”
“most money lenders in Bangladesh and many others worldwide charge interest on a “flat” rate, which principal and interest payments are included in weekly instalments of a fixed unvarying size.”

Should we see it in terms of APR?
“Bankers typically express interest rates in annual terms – that is, a given percentage per year – even when the loan is taken for just a few months or for longer than a year. The APR helps customers compare prices against the same yardstick. That can be useful, but the diaries also show that converting a flat fee on a one-week loan for a small amount of money to an APR, and then comparing it to the APR for a two year business loan misses the essence of the transaction. ”
“a poor person may sensibly pay 50 cents to borrow $10 for a day or so to tide her over a problem, even if the annualised rate calculates to more than 500 percent.”

Which other factors adjust the price?
“prices adjust to many factors: to personal relationships, to prior obligations between borrowers and lenders, and to the relative status of the partners, as well as the loan’s value, maturity purpose, source, and the likelihood of default. By taking into account data on how often loans are rescheduled or forgive, and how quickly they are repaid, we get a better sense of what prices mean in the financial lives of the poor.”

Is interest rate compounded in short-term loans for poor people?
“Interest is rarely compounded sometimes it remains the same flat fee until you repay the loan, even if you’ve paid back some of the principal.”
“..money-lenders rarely use compounded interest. This makes their interest rates easier to understand and calculate. It can also favour borrowers who pay slowly. A customer who failed to pay anything toward his loan would owe interest of only 30% of the principal alone, no 30 percent of the principal plus outstanding interest.”
the money lenders don’t adjust interest to take into account early repayment, in full or in part. This means that customers paying early or on time pay higher rates than those paying late. In “rich-world” banking, late payers are penalised since they incur costs in additional interest. But for many poor borrowers, it may be more accurate to treat financial returns and costs as flat fees rather than rates that accumulate fees over time.”

Are repayment delays factored into the nominal price?
“repayment delays are factored into the nominal price, with the effect that the customer who repays on time pays the highest price. This inverted pattern of incentives can be seen as one of the more unsatisfactory aspects of informal loan finance.”
“Half of the poor clients drag the repayments on a one-month term loan up to 90-100 days. Most delinquencies occur when the clients are away visiting their villages. Of each 100 poor clients, fiver are likely to default completely…We follow up at the most for three months beyond the scheduled loan period. We try to renegotiate the instalment size (making it smaller), but in the whole end business runs on trust and there’s no other means to recover our money.”

Who is the evil moneylender charging high interest rates?
“We realised that when some diarists spoke about taking a moneylender loan, they were in fact referring to loans taken from members of ASCAs. Suddenly our instinctive mental picture of the lender shifted from that of the “evil moneylender” to that of a group of conservative neighbourhood ladies trying to pool their savings together and earn the highest interest rate possible.”

Has average price of borrowing has reduced because of micro-finance arrival?
“Advocates of micro-finance hoped that money-lenders would be forced to reduce their rates. They haven’t but an increasing share of a growing total of lending is being done by micro-finance institutions, so the average price of borrowing has declined.”

Why poor people are ready to earn negative interest rate?
“… this is a small fee to pay for a service that efficiently bundles a month’s worth of daily savings into a usefully large lump sum, servicing the traders’ constant requirements for capital to buy inventory.”
“They get into a rhythm in which during each cycle they pay in a series of small amount and take out one big amount. If that series of cycles began, years back, with the lump sum, we would call each cycle, technically, a loan: but if it began with the small sums we would call it savings.”
“Those of us not familiar with this fact of life fall into a conceptual trap: $4 on $40 over 220 days doesn’t sound too bad as a loan interest rate, but minus $4 on $40 sounds unbelievable as a savings rate.”

Do poor people diversify in terms of instrument usage?
” just as we wouldn’t want to invest our entire retirement portfolio in hedge funds, the poor use different instruments that serve different needs in an attempt – not always successful – to balance their portfolios.”

I would like to hear more from you if you are using (or planning to use) these insights to build financial services for the next billion. Please do write to me at sagar@humane.network.

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