Why does microfinance assume more risk and how is this reflected in the price?

2024-06-14 17:11:02Pikëpamje SHKRUAR NGA AURORA SULCE

By Aurora Sulce, journalist

In everyday discussions about securing a loan, the interest rate is the most sensitive point. How much we will pay at the end of the month is what interests the vast majority of those who are looking for financing for various purposes, individual or for business. And the discussions become more "fierce" when discussing the differences of interests between the banking system and microfinance. I remember that interest was discussed with such "fire" even in the 2000s, when banks were criticized for having too high loan interest.

Believing strongly that everyone should be well informed before taking a loan, preferably even consult with specialized people, as well as to answer those who often write to me regarding the issue of interests, I want to share some information about why microfinance carries higher interest rates and then, judge for yourself and get the loans where you think is best for you. 

Microfinance institutions came to life as a business model mainly because of the needs of the rural population and the level of poverty that characterized them. This business model was originally designed as a common fund of the members of a community, which helped certain of its members when they were in need or wanted to start some modest business activity. Regardless of the continuous contribution of community members, its needs go beyond savings, so foundations or non-profit organizations began to be created in different places, which help families or businesses in need to get out of poverty. Such a model exists even today in some countries such as India, Bangladesh, etc.

If we refer to traditional microfinance, it has always targeted the most fragile layers of the population and aimed to create opportunities for these layers to undertake private personal or family initiatives, with the aim of generating income and employment. But having a very low level of income, but also of financial education, the possibilities of these layers to service the loan often remained low. Also, in most cases, they have nothing to offer as a guarantee in the form of movable and immovable assets, so loans are often offered without guarantees and without collateral. Regardless of this, the microfinance model is built to support these layers of the population. , who do not have access to banking products and services due to their financial status. This additional risk compared to the banking sector assumed by microfinance is reflected in the prices of the products they offer to the public. However, it should be noted that microfinance offers loans with a relatively low value compared to the banking sector (the average loan varies from 350 thousand to 500 thousand lek for some institutions), and therefore the interest generated, regardless of a higher rate, has an absolute value relatively low. Small monthly installments are affordable by a good part of credit clients, and the quality of repayments in microfinance is similar to that of the banking sector.

The activity of microfinance in Albania has been practiced for more than 3 decades now, and has reflected a sustainability and continuous progress. The structure of microfinance loan costs varies considerably between different types of financial institutions. For banks, operational costs account for 12%, funding costs 2%, and risk costs 2.5%. Traditional microfinance organizations face higher costs, with operating costs reaching 18%, funding costs at 6%, and risk costs at 7%. In stark contrast, consumer credit entities face much higher costs, with operational costs rising to 57%, financing costs reaching 15% and risk costs rising to 19%. These figures highlight the unique financial landscapes and challenges each type of lender faces in the microfinance sector.

On the other hand, they enable financing with various purposes to help the needs of individuals, such as children's education, medical expenses, professional development, home repairs, other family expenses and mobility needs. The reasons for using this product in the region are the same.

Anyway, I repeat: everyone interested should be well informed about what they are signing, possibly get another opinion from experts in the field and then decide, to be clear about the terms of the contract and what they have rights and responsibilities.

In economics, there is an expression: "High risk, high profit" and this applies to everyone: individuals or businesses.