# No interest rate is too high

Recent coverage of microfinance has had a sharp focus on interest rates, implying some line between “reasonable” interest (associated with “social investment”) and “excessive” interest (associated with “loan sharking”).

In Nicaragua, President Daniel Ortega, outraged that interest rates there were hovering around 35 percent in 2008, announced that he would back a microfinance institution that would charge 8 to 10 percent, using Venezuelan money …
Damian von Stauffenberg, who founded an independent rating agency called Microrate, said that local conditions had to be taken into account, but that any firm charging 20 to 30 percent above the market was “unconscionable” and that profit rates above 30 percent should be considered high.
Mr. Yunus says interest rates should be 10 to 15 percent above the cost of raising the money, with anything beyond a “red zone” of loan sharking. “We need to draw a line between genuine and abuse,” he said. “You will never see the situation of poor people if you look at it through the glasses of profit-making.”

It seems very important that interest rates be transparent, i.e., clearly communicated to and understood by clients. It also is clearly important that there be no coercion, i.e., that clients not be pressured to take loans they don’t want to take. More debatable, but something that we support strongly, are additional measures to assess and improve the client experience, including monitoring overindebtedness, examining dropout rates, etc.

But if/when such things are in place, it is unclear to me on what grounds anyone can complain about interest rates being “too high.” If the terms of loans are clearly communicated, then I see no explanation for why clients would take out loans – unless they feel they have no better alternatives.

What objection can be raised to a 100% interest rate, if the next-best alternative is a 500% interest rate (as I have been told some informal moneylenders charge)? What objection can be raised to a 500% interest rate, if there is no other way for people to get credit? When a loan could result in a sick child’s being treated, or a profitable micro-business, what fee is too high for that benefit?

When MFIs charge more than they need to in order to make a profit, that’s an opportunity for someone else to come in and undercut them. If no one else is coming in, that implies that the costs and difficulty of providing credit in an area may be higher than they appear to an outsider. For an outsider to declare profit margins “too high” strikes me as ungrounded and unproductive, especially when that outsider has not tried to provide credit for less in the same area.

Microfinance exists to improve the lives of the poor. Ideally, then, microfinance institutions would be judged by their effects on people’s lives. Instead, they’re being judged by simplistic financial metrics that crudely attempt to get at the moral uprightness of the organizations. To me that’s a very familiar situation.

I believe the ideal way to evaluate an MFI is to look directly at its impact. When this isn’t possible, proxies for client participation and satisfaction may (debatably) be appropriate. I don’t see any place for universal rules about how much interest can be charged.

• Oscar on April 16, 2010 at 1:00 pm said:

“When MFIs charge more than they need to in order to make a profit, that’s an opportunity for someone else to come in and undercut them. If no one else is coming in, that implies that the costs and difficulty of providing credit in an area may be higher than they appear to an outsider. For an outsider to declare profit margins “too high” strikes me as ungrounded and unproductive, especially when that outsider has not tried to provide credit for less in the same area.”

Amen to that. It’s way too early (since private capital only became a major microfinance presence in the last decade or so) to make judgments about interest rates being too high.

• Jonah S. on April 16, 2010 at 8:40 pm said:

I have some trouble picturing borrowers benefiting very much from loans offered at interests rates between 100% and 500%, especially if they’re compounded (are they?). Such loans would be useful to borrowers who are unexpectedly in need of an amount of cash that’s small relative to their income for a short amount of time. But on the face of things, borrowing at such rates for a year or longer would seem to be at best useless (if the amount borrowed is very small) and at worst a recipe for disaster (if the amount borrowed is large relative to the borrower’s income).

I have trouble seeing how charging 100-500% interest rates for long term loans could be profitable to lenders without the lenders hurting their clients (whether by engaging in deception/coercion or because the clients are making poor choices, an anecdotal example being described in section 10.5 of Holden’s “informal moneylenders” link). This is why, to a first approximation, very high interest rates signal trouble to me.

I agree that impact is what matters – the question that I have is just how such MFIs could *in principle* have a positive effect on their clients while still turning a profit. Would be interested to hear any thoughts on this point.

Is the period of lending usually quite short?

• Nick B. on April 18, 2010 at 12:47 pm said:

Suppose a lot of people were hanging off cliffs. These people could easily be helped by me. But I decide to charge them $10k each to be helped off the cliffs. They could say no. But many people take the deal, and we mutually benefit from the transaction. Now, you couldn’t complain that I made things worse by going around and offering people these deals. But you could complain that I could have offered them deals which would have done more good. So your question: “What objection can be raised to a 100% interest rate, if the next-best alternative is a 500% interest rate (as I have been told some informal moneylenders charge)? What objection can be raised to a 500% interest rate, if there is no other way for people to get credit? When a loan could result in a sick child’s being treated, or a profitable micro-business, what fee is too high for that benefit?” I could ask them to offer rates that do more good for their customers. This complaint can’t apply only if no better deal could be made. Why is it so hard to believe that a better deal could be made? In the years before microfinance, where moneylenders charged much higher rates, couldn’t those folks have made better deals? Why couldn’t some microfinance institutions be able to make better offers than they are making now? I agree I can’t look at some interest rate and say whether it is good without knowing specifics of the situation, I can’t complain that these institutions are making things worse, and that we should only care about the impact, but there is a long distance between these claims and the claim that every interest rate anyone ever accepts under full information is optimal. Or are you saying less than I think you are? • R. Y. on April 18, 2010 at 7:50 pm said: I am not quite sure if impact can be separated from interest rates entirely. Even if microfinance is merely another method by which the poor manage their financial lives as you’ve mentioned before, I don’t quite understand how paying lower interest rates would not improve their financial lives. (And several studies have demonstrated the strain high repayment rates cause borrowers.) Granted, it’s probably impossible to set a single universal rate–context, context, context. But to deny the possibility that some rates could simply be too high is to remove all social responsibility from the debate. It isn’t merely a question of transparency, perhaps usurious moneylenders are quite clear about their rates. There could be many reasons for market failure. I imagine lack of information, lack of financial understanding and lack of choices contribute amongst other reasons to less than optimal conditions. The poor probably had no options when faced with a money lender, they probably have not that many more when faced with an MFI. To say the competitive marketplace would punish MFIs that charge too high an interest rate is putting entirely too much faith in the rational markets model. To say There Is No Alternative to 100% is a simplistic way to end the debate. Indeed, a more holistic understanding of an institution is needed (and thank you for stressing that), but to say interest rate aren’t part of that assessment is shortchanging it. • Holden on April 19, 2010 at 7:56 pm said: First a clarification on what we mean by “no interest rate is too high.” We do not mean: the mere fact that an MFI charges interest rate R means that R is the socially optimal rate. We do mean: the mere fact that an MFI charges interest rate R cannot tell you that the MFI is doing harm or that the MFI can/should be charging less. The line that summarizes our view (from the post above): “For an outsider to declare profit margins ‘too high’ strikes me as ungrounded and unproductive, especially when that outsider has not tried to provide credit for less in the same area.” A “high” interest rate raises the possibility of damage and exploitation, but so does a “low” one. The “higher” the interest rate, the greater the potential damage if people are simply being deceived, but also the greater the accomplishment if they are not (in which case a high interest rate can be seen as an indicator of just how difficult and/or valuable it is to supply credit in that area). Nick and R.Y., I believe that addresses your issues. Though to Nick, I want to add that I think the cliff analogy is highly misleading. The analogy describes a situation of complete and extreme monopoly: your character in the analogy, by sheer luck, is the only person able to help and the only person who even knows about the predicament. If you imagine that the problem of people hanging off cliffs were well-recognized, and billions of dollars were spent every year on trying to figure out how to help as many people as possible get back from hanging off cliffs, and there were one firm going around charging$10k to help people off and succeeding, you would have to accept a strong possibility that this firm was reaching cliffs that all the other people trying to help couldn’t, and that requiring it (or pressuring it) to lower its price could easily (a) result in fewer people being pulled off cliffs (b) reduce the incentives for other firms to figure out what that firm was doing, and eventually get in and undercut them. Of course it would also be possible that the firm was just exploitative, but it would be naïve and unhelpful to lobby based on no fact other than the high-seeming price.

Jonah: my impression is that moneylenders give very short-term loans (at annualized rates in the neighborhood of 500%) while microfinance institutions give longer-term loans (official term may only be a few months, but many of their clients are constant borrowers).

I don’t find it at all hard to believe that a high-interest-rate, long-term loan could help someone. Speaking broadly, there are plenty of things for which I would pay a large multiple of the price if it were the only way to get them, and that’s what a several-hundred-percent interest rate loan comes down to. Speaking more hypothetically and specifically:

• A client could easily be willing to pay 10x the market price for a doctor’s visit when their child is sick, or a wedding when their child gets married. Borrowing from a moneylender for 1 month at 30% could be an excellent deal in such circumstances. 30%/month is equivalent to a 360% “nominal APR” or ~2300% “effective APR.”
• Now say that an MFI enters charging 25% total over 3 months (100% “nominal APR”, 144% “effective APR.”) Say that on average, something like a wedding or doctor’s visit comes up about once every 3 months. It is clear that the client benefits from switching from the moneylender to the MFI.
• Another possibility is that loans are used to run businesses. For example, say that a woman wants to sell clothing and beadwork, which would require purchasing fabric and beads up front. Is it possible that she could sell the completed product for so much more than the cost of the fabric that she can make back a 144% annualized interest rate? It seems very possible. For one thing, if credit is universally scarce in an area, fabric and other “capital stock” may become quite valuable relative to the pure costs of the materials, and clothing could easily sell for a significant markup over the fabric’s sticker price. Also, interest rates are generally quoted in annualized terms, but note that if the woman turns over her stock of fabric once a month, she can come out ahead even at a profit margin under 10%.
• Nick B. on April 20, 2010 at 8:37 am said:

Holden: Ok we have no further disagreement. The title “No interest rate is too high”, however, makes it sound like you think that no interest rate (under full info etc.) can be criticized.

The point of the cliffs analogy was just that little follows about the optimality of a transaction from the fact that it was mutually beneficial. I think this holds even if you add competition. The point is weaker as competition approaches perfection, but I doubt competition in microfinance markets is anything like perfect. The very fact that the industry spread so quickly indicates that there wasn’t anywhere near perfect competition.

• Holden on April 21, 2010 at 2:51 pm said:

Nick, I admit the title can be read in different ways … the intended meaning is that any interest rate can be good and any interest rate can be harmful. One should assess the situation as a whole, rather than (as the article I quoted from does) drawing conclusions from the interest rate itself.

Regarding mutually beneficial vs. optimal, it depends on what you mean by optimal. If you mean “the best that could be achieved in theory,” no outcome is socially optimal. It sounds from your analogy more like you mean “without gratuitous and morally repugnant extortion, beyond what an average person would do in the same situation.” But I think only a very low level of competition is needed to start equating “mutually beneficial” with “optimal” in that sense, and I think microfinance is over the bar.

My preferred use of “optimal” is “not improvable by steps you and I can practically take.” (Thus, something could be optimal from my perspective but not from the perspective of someone more involved and knowledgeable who has the ability to undercut an existing MFI.) I don’t think that lobbying for lower interest rates, in a general/universal context (as the article discussed implicitly suggests), would improve outcomes for microfinance clients.

• Sam Gardner on April 22, 2010 at 3:25 pm said:

Indeed, high is relative. In high risk ventures, without collateral backing, in a country with inflation of 10 % or above, 30 % can be very reasonable.

What is not reasonable is the creation of institutions that subsidise credit and then ration it to a selected group, not based on merit, but on “other criteria”, killing the decent institutions charging sustainable rates in the process.

• Compare ISAs on April 29, 2010 at 7:20 am said:

When MFIs charge more than they need to in order to make a profit, that’s an opportunity for someone else to come in and undercut them. If no one else is coming in, that implies that the costs and difficulty of providing credit in an area may be higher than they appear to an outsider. For an outsider to declare profit margins “too high” strikes me as ungrounded and unproductive, especially when that outsider has not tried to provide credit for less in the same area.Compare ISAs