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Interest rate and its determination is one of the trickiest issues in microfinance. Most people say MFIs are charging too much, and some government agencies are even putting cap on the lending rates of financial institutions. Mission drift is an increasing phenomenon as more MFIs are shifting to bigger loan sizes and catering to the more “dependable” microenterprises and small and medium enterprises (mMSE) to remain profitable and to satisfy the investors’ expected returns. This mode is being countered with the promotion of responsible finance, that is, delivery of financial services in a transparent, inclusive and equitable fashion (CGAP 2011). It is in this context that determining cost-covering interest rate is relevant. Policy-makers of MFIs should understand how interest rate on loans is determined and how it affects their institutions bottom-line and their clients’ survival and capacity to pay. They can do this by being familiar with the elements of interest rates and develop the skills on how to work on the various elements to come up with the ideal interest rate on their loan products.
Interest rate is generally defined as, the charge for the use of money over time. Several concepts are related to this idea. The first is opportunity cost which refers to the cost of the missed opportunities. Second, the time value of money which refers to the earning potential of the money and it future value when invested now. The third is borrowers transaction cost which refers to the expenses and opportunity cost of the clients when transacting business with a financial institution. Most often, this concept is neglected as financial institutions focus only on their cost and their risk management practices. All the three concepts directly affect cost of doing business for financial institution. These have to be considered in determining interest rates.
In determining cost-covering interest rates, the following core elements should be estimated:
Operating cost. This refers to all recurring expenses of the MFI including administrative overhead and expenses directly relating to credit management.
Loan losses. Actual written-off loans should be recovered. This can be done by imputing the losses to the interest rate of the succeeding year. High volume of written-off loans will directly affect the equity of the institution. Loan loss provisioning on the other hand will affect the return on equity and the dividends of the investor. Controlling defaults and PAR will ensure that this element will not reflect to higher interest rate on loans.
Cost of funds. Most MFIs leverage their capital. As such, they have to pay for the borrowed funds, whether it is commercial or soft loans from development agencies. If the MFI has a lot of lenders with varying interest rates, it can be computed on the basis of “weighted average cost of capital”. Deposits from members and clients with paid interest rate on savings fall in this category. It is not enough to impute the interest rate on savings as the cost, but rather, to include the opportunity cost of the liquidity reserve set aside as a requirement by the regulatory agency, and the reserve set aside to service withdrawals.
Desired margin. This element refers to the profit or the envisioned income of the institution.
Other than the four core elements, taxes and inflation are also included in the determination of interest rate. Actual taxes paid can be imputed, while inflation can be determined by looking at the historical trend for the past several years. This will enable the institution to preserve the value of its financial resources.