Microfinance took a wrong turn in Mexico some time ago, and now Mexican MFIs are notorious for charging exorbitant interest rates that are obscured by a lack of transparency, which is a recent trend in microfinance. The case of Bank Compartamos is perhaps the most prominent; it is a for-profit microfinance provider and claims to charge around 85% on loans (in 2008), while reminding us this is the lowest rate in the microfinance market.
Recently, the pope passed a verdict about charging high interest rates from the poor, and though his figure alone is difficult to digest, it hardly depicts the whole truth. A case study by Chuck Waterfield, Explanation of Compartamos Interest Rates, reveals that the rate to the borrower is actually 129% a year, while the rate that is marketed to clients is a mere 4% per month.
The Reality behind Compartamos’ Interest Charges
While the report gives a detailed description of how obscurity is introduced in interest rate calculations, this post offers a basic summary of the Waterfield’s process.
Typical micro loan size/principle: 3000 pesos
Duration of micro loan: 16 weeks
Weekly payments on micro loan: 221.66 pesos
Marketed interest rate on micro loan: 4% per month
Interest rate mentioned in footnotes of credit document: 105% per year, effective annual interest rate (EAIR), or average percentage rate (APR)
The rate paid by the customer: 129% per year, EAIR or APR
Bank Compartamos Transparency Issue 1: Difference in interest rate calculation methods
A flat interest rate of 48% (=4*12) is charged on the 3000 pesos principle, even if part of the principle is paid back through weekly payments. This method is akin to the practice of loan sharks because it fails to recognize that the outstanding balance is falling. It’s the same as charging 86.8% on a declining balance basis, which is interest rate charged only on the outstanding balance (i.e. interest charge will continue to fall as the 16th week draws closer).
Bank Compartamos Transparency Issue 2: Charging 4% per 4 weeks, not per month
Bank Compartamos claims to charge 4% interest per month, but they actually charge 4% per 4 weeks. So according to the bank’s marketing material, the annual rate is 48% (=4*12) but in reality, it is 52%. How is that possible?
We know one month is slightly longer than 4 weeks. In fact, there are 52 weeks in a year, which makes a total of 13 sets of ‘4 weeks’, i.e. 12 months + 4 weeks. Therefore, by charging interest rate on a quad-weekly basis, Bank Compartamos actually charges 4%*13 = 52% per annum.
This raises the EAIR/APR to 93.7%.
Bank Compartamos Transparency Issue 3: Including Taxes
Value Added Tax of 15% is passed on to micro credit customers, who must pay this in addition to the interest charge. This isn’t shown in the payment schedule handed to the client, but it further raises the EAIR/APR to 107.1%.
Bank Compartamos Transparency Issue 4: Brushing ‘Compulsory Savings’ Under the Carpet
Most microfinance providers require customers to deposit a small amount of cash in the bank before the micro loan is approved. If the borrower defaults, the bank seizes this money. Bank Compartamos asks borrowers to deposit 300 pesos as‘partial loan collateral’. In other words, the borrower only gets a loan of 2700 pesos, but pays interest on the full 3000 pesos.
When factored into the payments, this raises the EAIR to 129%.
This is it. Sadly, Muhammad Yunus started microfinance as a means of helping the poor, but the case of Bank Comparatamos shows some MFIs face several challenges.
There are some ways to control the charging of unjust interest rates but no single technique is effective. What do you think is the solution to this blaring exploitation? Can traditional elements of microfinance theory and practice solve this issue or are new mechanisms needed?
P.S. I thank Martin Hadsell for introducing me to this wonderful case study.
What a heck? I was taken aback with this post. I’m glad you put these things out. While I was trumpeting that microfinance do help the poor, our program is doing the same as compartamos at lower rate, though. (sigh)
I have to take a look once more in our program and dig some more. Thanks.
Yes, it was shocking to me too. Do share the particulars about your microfinance program and how you think it is similar to Bank Compartamos’s case. The point I am trying to make is that there should be more transparency in prices. We know MFIs need to charge interest rates higher than market rates, but they often hide the actual interest rate they charge, and charge more interest than they need to stay sustainable or to grow (as Grameen Bank does). As a result, MFIs mistake profit orientation with greed
This is a great example of how small ‘miscalculations’ and number fiddling can add up to a huge difference in interest rate s and even in the perceived intentions of an institution. Thanks again for a thoughtful and well-researched post!
Thanks for the comment, Danny! Complex calculations like these exploit the illiteracy of clients and I’m pretty sure the advertised interest rate is often lower than the actual rate paid by the clients in a majority of cases because sales tax and compulsory savings are rather common. I’m trying to conduct a similar study in Pakistan for a few banks but it’s extremely difficult to get access to this kind of information, for obvious reasons.
Fehmeen, thank you for featuring this analysis done by MicroFinance Transparency CEO & President Chuck Waterfield. I want to draw your attention to an updated version of this paper posted in the new Resources section of the MicroFinance Transparency website: http://www.mftransparency.org/pages/wp-content/uploads/2010/06/The-Challenge-of-Understanding-Pricing-of-Micro-Loans-MFTransparency-2010-06.pdf
MicroFinance Transparency works to promote pricing transparency in microfinance from the perspective of client protection. We offer training and educational tools to MFIs and other industry participants around the world. This helps to avoid cases like Florentino’s where MFI managers are unknowingly presenting prices to their clients in confusing ways. We also collect and publish pricing data for microfinance products to promote transparent pricing practices, enable comparison of rates charged by different institutions and enhance understanding about the pricing of microfinance products in different markets. Visit our site to learn more: http://www.mftransparency.org
Your welcome. I appreciate the effort MFT has been putting into enhancing the transparency in this sector (which is the need of the hour) and I’ll be glad to help. If there’s any promotional material/information/papers you’d like people to know of, please send them my way and I’ll be glad to publish them. Regards.
Yes, this is a shocking news for all the proponents of Microfinance. All these loan sharks should be punished hard by the society (as there is no legal framework till now).
Hello Lehana,
Thanks for the comment! I agree, it’s very shocking and disturbing, and I imagine the rate of empowerment of the poor in such countries would be very low and that defeats the purpose of microfinance altogether (even though some MFIs may provider slightly better rates compared to loan sharks). Unfortunately, the Mexican government hasn’t done anything (as you pointed out) and it is certainly their responsibility to enforce consumer protection laws if these MFIs do not do it properly on their own. The Bangladeshi government, for instance, has placed an interest rate cap for MFIs (around 30%) and although some complain this belittles the freedom of markets, I would argue otherwise.