Interest rates

Interest represents the cost of money - what a borrower pays in order to rent money for a certain period of time. Interest rates help determine the allocation of money because the demand for money is influenced by its cost. Interest is an income to lenders and a cost for borrowers which must be more than matched by profit generated from the use of the funds. To ensure self-sufficiency, institutions have to design an interest rate and fee structure that will cover their costs - cost of funds, operating costs, loan loss provision and effect of inflation.

Interest rates are manipulated by governments to promote investment, control inflation and fulfil other elements of fiscal policy. Unfortunately interest rate restrictions usually undermine a financial institution's ability to operate efficiently and effectively. It is an important issue for policy-makers.

Library Resources

resource title type year resource
Competition and Microcredit Interest Rates Article 2006

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This article focuses on helping microfinance institutions, policy makers and donors assess the stage of development of competition in a particular market and determine whether appropriate conditions are in place to foster sustained interest rate reduction. The article then uses its initial paradigm to analyze the condition of the MFI markets in Bolivia, Bangladesh and Uganda.

The article outlines four stages of competition through market development phases:

  1. Pioneer: In this initial stage firms are few, growth is slow, and the market is concentrated in small areas.
  2. Take-off: At this point the success of the idea causes rapid take growth and expansion in the market. Firms begin to compete in product characteristics and service. The market remains quite fragmented although leaders begin to emerge.
  3. Consolidation: The market growth slows and the numbers of firms reduce as competition drives the market to consolidate with clear leaders emerging. Firms compete on price.
  4. Mature: Steady, natural growth of the established market leaders dominates this market. Firms compete mainly on brand and price.

The article finds that Uganda is at the end of the take-off phase and expects within the next few years to be in the phase of consolidation. Bangladesh seems to have reached the consolidation phase, although the market continues to grow rapidly. Bolivia is entering the maturity phase.

The article concludes with a number of policy and donor recommendations. The recommendations are to require transparent comparable pricing structures by providers, promote consumer financial literacy, collect and assess credible market-level information, and develop reliable consumer credit bureaus.

Understanding and Dealing with High Interest Rates on Microcredit Article 2006

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In this brief document, Nimal Fernando defends the high interest rates currently charged by microfinance institutions and cautions against policy interventions (such as an interest rate ceiling). His main points are summarized below:

  • Just like any business, MFIs must charge prices high enough to cover their costs
  • Concessional funds (donor funds) cannot be seen as a permanent source of funding for MFIs and provision must be made through interest rates to sustain the lenders’ operations
  • Because of the vast difference in transaction costs and sizes of microfinance loans it is inappropriate to compare them to conventional loans
  • A rate ceiling will prevent lenders from recovering costs and cause a flight of lenders form the markets, depriving microfinance customers of adequate service providers
  • Empirical evidence shows that liberal interest rate policies breeds strong growth in the microfinance industry, whereas interest rate regulation does not

In conclusion, Fernando states:

Microcredit interest rates are high because microlending remains a high-cost operation. The key to reducing these rates in a sustainable manner is to reduce costs through improved market competition, innovation, and efficiency. Interest rate ceilings are not an appropriate intervention, and there are no quick solutions or shortcuts. To provide affordable finance to poor households in Asia and the Pacific, policy makers need to recognize, and rectify impediments such as a lack of physical, human, and financial infrastructure, promote competition and efficiency, and be proactive in providing an enabling environment for MFIs to develop in a sustainable manner.

Author Fernando, Nimal
Publisher Asian Development Bank
Number of Pages 18 pp.
Primary Language English (en)
Region / Country Global
Keywords Interest Rate, Agricultural Microfinance
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Do Interest Rates Matter? Credit Demand in the Dhaka Slums Paper 2005

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If the demand for credit by the poor changes little when interest rates increase, lenders can raise fees to cost-covering levels without losing customers. This claim is at the core of sustainable microfinance strategies that aim to provide banking services to the poor while eschewing long-term subsidies, but, so far, there is little direct evidence of this.

This paper uses data from SafeSave, a credit cooperative in the slums of Dhaka, Bangladesh, to examine how sensitive borrowers are to increases in the interest rate on loans. Using unanticipated between-branch variation in the interest rate we estimate interest rate elasticities of loan demand ranging from -0.73 to -1.04. Less wealthy accountholders are more sensitive to the interest rate than (relatively) wealthier borrowers (an elasticity of -0.86 compared to -0.26), and consequently the bank’s portfolio shifts away from its poorest borrowers when it increases the interest rate.

This paper is set out in the following sections:

  • Section 1: Introduction
  • Section 2: Reviews the prior literature and debates on interest rates
  • Section 3: Provides details on SafeSave
  • Section 4: Summarises the data
  • Section 5: Outlines the identification strategy
  • Section 6: Presents results on the interest elasticity of loan demand
  • Section 7: Concludes
Author Dehejia, R, Montgomery, H and Morduch, J
Publisher ADB Institute
Number of Pages 33 pp.
Primary Language English (en)
Region / Country Global
Keywords Interest Rate, Access To Credit, Sustainability
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The Impact of Interest Rate Ceilings on Microfinance Brief 2004

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This donor brief notes that interest ceilings are found in many countries throughout the world. With the expansion of microfinance in developing countries, many legislators and the general public have found it difficult to accept that small loans to poor people generally cost more than normal commercial bank rates. The brief argues that though meant to protect consumers, interest rate ceilings almost always hurt the poor.

The first question considered is whether is whether interest rate ceilings are an effective way to protect the poor? The discussion includes anecdotal evidence from Nicaragua, West Africa and South Africa. Given the conclusion mentioned above, the brief then moves on to look at alternative ways to protect consumers, where it discusses consumer protection laws or schemes, public disclosure of loan costs, and efficiency, scale and competition.

Finally, the discusses the actions donors can take in relation to interest rate ceilings – set a good example, inform and educate policy makers, support transparency and standard reporting, including an emphasis on efficiency and to foster growth and competition.

Subsidizing Microcredit Interest: How Important Is It to the Poor? Paper 2004

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Ethiopia is characterised by a high degree of poverty among the population. Although Government strategy identifies microfinance as a good entry point for achieving development objectives and there are 23 licensed MFIs in operation, only a small proportion of people have access to their facilities. Thus the rural financial landscape remains dominated by informal mechanisms. The Amhara Credit and Savings Institution (ACSI) was established in 1997. By September, 2004 it had over 337,000 active loan clients but the estimated potential market in the region is about 2.9 million clients.

This paper, which has been written by the Head of the ACSI Planning and Monitoring Department, explores how reaching out to more clients in remoter areas will increase operational costs, particularly in light of the level of support that the poorest clients need. However, ACSI has continued to commit itself to a low interest rate, namely 12.5%, even though the transaction costs of providing microcredit in remote and isolated areas are much higher than those for providing standard commercial loans. The author questions this policy and observes that subsidising the interest paid by clients usually has a counterproductive role by reducing the very "access" by the poor that it sets out to promote.

In conclusion this paper suggests that while setting a realistic interest rate should not be a licence for higher costs and inefficiency, if an MFI is to offer its financial services to poor and marginalised people living in remote and peripheral rural areas (with non-existent, inadequate or defective infrastructure) and who require very small loan sizes and hence high transaction costs, interest rate capping should not constitute a bottleneck.

Author Gobezie, G.
Number of Pages 12 pp.
Primary Language English (en)
Region / Country Global
Keywords Interest Rate, Transaction Costs
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Interest rates in the field of microfinance: a technical or political choice? Article 2003

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How to establish appropriated interest rates has been a common discussion in the rural finance field. This debate in many ways reflects the controversy of rural finance: how to be sustainable and reaching the poor at the same time. The debate has been recently fed by two perspectives. The first one states that interest rates should be fixed by market mechanisms, which in a way allows the sustainability of the service (even though costly). The second one argues that is still necessary to subsidize interest rates, in order to create incentives for rural development, and having in mind the needs and real capacities of repayment of agriculture activity.

The authors argue that it would be necessary to revise some common arguments, as well: subsidy policies are an archaism, and high rates of interest are justified in order to provide sustainable financial services, like some experts argue. Nevertheless, it would be necessary to revise what an interest rate means from the perspective of both clients and suppliers of financial services.

From the financial institutions’ perspective, high interest rates are justified in order to cover costs such as money cost, failure-to-pay risks’ cost related to the loan, and loan management cost. From the clients and rural development policy makers’ perspective, it is argued that in order to foster macroeconomic growth, the price of money should be reduced. However, what is more important, the price of the service or sustainable access to the service?

Two approaches arise from this debate: - to develop an interest rate policy based on institutional sustainability; or – a political interest rate should be fixed. In order to conceal both approaches, the authors provide the following recommendations:

  • Scale economies, technical innovations and more professionalism can reduce interest rates.
  • Differentiated interest rates should be applied based on the use of the loan.
  • To find ways to align farmers’ logic and bankers’ logic.
  • In savings and loans networks, reasoning based on differentials is essential.
  • To favour alliances between decentralized financial services and farmers’ and producers’ organizations.

This article is recommended for financial service providers, policy makers, and managers of cooperatives and producers’ organizations.

Author SOS FAIM
Publisher SOS FAIM
Number of Pages 8 pp.
Primary Language English (en)
Region / Country Global
Keywords Interest Rate, Cost Accounting
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Making Sense of Microcredit Interest Rates Document 2002

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This donor brief highlights some of the key issues related to microcredit interest rates and the role of donors. As interest rate subsidies are often a part of financial policy, this brief addresses when and how subsidies are appropriate.

Interest rates and rural credit: subsidise or liberalise? 1994

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The environment for rural financial intermediation has changed significantly in recent years. The concept of privatization has been embraced by an ever increasing number of countries, and the role of markets in the determination of prices for traded agricultural products has been enhanced. Food and agriculture input subsidies as well as those for agricultural credit have been reduced or eliminated. As subsidies on credit are reduced the cost of credit increases, and as subsidies on inputs are reduced the amount of credit needed rises. Traditional credit subsidies have usually taken two forms: concessionary, often below the rates of inflation, interest rates on loans and acceptance of loan defaults. Both types erode the value of loan portfolios and may also endanger the viability of the financial institution involved. Unfortunately, neither the interest nor default subsidy have proven to be an efficient tool for alleviation poverty, mainly since access to loans is usually correlated with borrower wealth. This has led a number of policy makers to experiment with more direct avenues for addressing poverty such as programmes in health, education, nutrition, and welfare assistance.

The present document, prepared by Mr. J-L Pizarro, aims at giving a panoramic vision of the main characteristics of the financial liberalization process, its possible consequences for rural financial intermediation, and the conditions that could contribute to improved financial deepening in rural areas. It describes the context and justification of the financial liberalization policy in contrast with that of interest subsidies and, in doing so, focuses on their respective effects, beneficial and detrimental, on rural financial markets and their clients. It also analyses the framework for the implementation of a financial liberalization policy in the field of rural finance and discusses the reasons why subsidized agricultural credit projects or programmes still continue. Finally, it makes an attempt to systematize rural development projects having a financial component, in relation to the degree of the financial development of the region or country where they operate.

Author Pizzaro, J-L.
Publisher Food and Agriculture Organization of the United Nations (FAO)
Number of Pages 42 pp.
Primary Language French (fr)
Region / Country Global
Keywords Interest Rate, Subsidies
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