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How much Interest Rate is “Too High”?

For starters, An interest rate is the percentage of principal charged by the lender for the use of its money.

In this write-up, we would be concentrating more on Microfinance Institutions.

There is a general belief that Nigerian MFIs charge their customers an outrageous interest rate. To determine if this claim is true or not, there are a lot of factors to be considered.

And this brings us back to the question, How much interest rate is too high?

The average interest rate offered by Nigerian Microfinance Institutions is 5% monthly( sometimes flat or reducing balance( read more at https://www.freshticles.com/an-insight-into-the-nigerian-microfinance-industry/), which translate to approximately 60% per annum.

Please note this is just the average, Some charge as low as 3% per month while some charge as high as 10% per month.

While most people always claim these rates are too high, MFIs always claim that is the best they can do, so who is right? Well, this is not a court of justice, we are not here to give a judgment. We would allow the audience to answer the question. After reading this article, we hope you would be able to make an informed decision about this issue.

Let us start by reflecting on this quote from the Nobel Peace Laureate, the pioneer of Microfinance:

“Those who charge more than 15%(per annum) over the cost of funds have “just left the micro-credit area and joined the loan-shark area”.

In laymen terms, cost of funds (COF) is the interest that a financial institution must pay to investors for the use of their money to make loans to borrowers.

The statement makes it clear the range of interest rate an MFI should charge borrowers.

For instance, if the cost of fund to the MFI is 25%, then it can not charge customers more than 40%(25 + 15).

So, the next question is: How much do these funds cost the MFIs?

MFIs get fund from different sources, both local and foreign. These funds come at a different cost.

Customers’ deposit is one of the sources of finance. While this usually constitutes the lowest percentage of their portfolio, It is almost always the cheapest.

MFIs offer customers an interest rate between 3% to 20% per annum on their deposit depending on the amount and tenor of the deposit. Meaning the MFIs should, in turn, be able to offer an interest rate between 18% to 35% to their borrowers. But it is not that simple since the deposit is usually a small percentage of their portfolio.

Let us look at the other sources of finance:

A reliable source from an impact investment firm in Switzerland makes me understand that the rate at which they lend to MFIs depends on many factors such as the stability of operating country’s economy, their corporate finance structure, their Portfolio at risk and also the strength of the country’s local currency(if they are disbursing to them in local currency).

It is usually around 10% to 12% in USD, but with hedging cost, it can go as high as 25% to 40%, depending on how stable the local currency is.

This is applicable to MFIs that get funds from foreign Investors.

For those that source their funds locally, I would expect their cost of fund to be lower, since there is no foreign exchange risk.

Let us assume the average cost of fund for all MFIS is 40%, according to the “15% above the cost of fund rule”, then no MFI should charge borrowers more than 55%.

Do our MFIs still charge more than 55%? The answer is certainly yes.

Another factor we have to consider is whether this 15% profit margin can cover the operating cost of the MFIs and still leave room for profit?

Is there a need for Micro-Lending to be subsidized by the government?

Although, Microfinance is established to tackle poverty, yet there is a need for it to be profitable and sustainable.

There are a lot of questions we need to ask ourselves:

On the part of the borrower, do we sincerely think a customer can conveniently pay an interest rate of “60%” without hurting his or her business?

I understand there is a high default among Microfinance borrowers, the average portfolio-at-risk of MFIs in Nigeria is reportedly close to 50%, do we think the “high-interest rate” contributes to this? or Do we think it is otherwise, is micro-lending rates high due to the high portfolio at risk? High risk vs High reward?

The stakeholders in Microfinance really need to do some soul searching, so as not to defeat the primary purpose of Microfinance.

The credit business is the same as trading, what you buy is what you sell, yet there is always a need to establish what is considered as a reasonable profit gauge so Microfinance would not become a tool through which the “The Rich” takes from “The Poor”.

Thank you for reading, and I hope after reading this write-up, you are able to answer the posing question: How much interest is “too much interest”?

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Written by AMEEN AJIBOLA

I am a graduate of Science who has spent the past six years building a career in the Financial Services Industry. I have experience in credit and financial analysis, microfinance lending, project management, sales, monitoring and evaluation, financial due diligence, Investment Management, and business development.

I am an MBA candidate at the University of South Wales. In addition, I am a last stage student of the Chartered Institute of Stockbrokers.

I have been opportune to work with one of the biggest microfinance networks in West Africa, the biggest pension fund manager in West Africa and the biggest bank in Africa.

I have extensive work experience in international development programs in East and West Africa.

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