8. Why do MFIs charge high interest rates?

To maintain and increase its services over time, an MFI must charge interest rates high enough to cover the cost of its loans.

There are three kinds of costs the MFI has to cover when it makes micro loans. The first two, the cost of the money that it lends and the cost of loan defaults, are proportional to the amount lent. For instance, if the cost paid by the MFI for the money it lends is 10%, and it experiences defaults of 1% of the amount lent, then these two costs will total €11 for a loan of €100, and €55 for a loan of €500. An interest rate of 11% of the loan amount thus covers both these costs for either loan.

The third type of cost, transaction costs, is not proportional to the amount lent. The transaction cost of the € 500 loan is not much different from the transaction cost of the € 100 loan. Both loans require roughly the same amount of staff time for meeting with the borrower to appraise the loan, processing the loan disbursement and repayments, and follow-up monitoring. Suppose that the transaction cost is € 25 per loan and that the loans are for one year. To break even on the € 500 loan, the MFI would need to collect interest of € 50 + € 5 + € 25 = € 80, which represents an annual interest rate of 16%. To break even on the € 100 loan, the MFI would need to collect interest of € 10 + € 1 + € 25 = € 36, which is an interest rate of 36%. At first glance, a rate this high looks abusive to many people, especially when the clients are poor. But in fact, this interest rate simply reflects the basic reality that when loan sizes get very small, transaction costs loom larger because these costs can’t be cut below certain minimums. And informal money lenders and people’s own savings and loans groups often ask even much higher rates.