FINCA’s loan officers apparently get a lot of complaints about high perceived interest rates in Tanzania. Their credits starts at 2.5% interest per month, and depend on loan amount and borrower risk. One of FINCA’s competitors advertises loans with a yearly interest rate of 25%. Short of discussing usury and setting aside culturally influenced notions that an interest should not be paid but rather received (the Swiss national bank is still imposing negative interest rates on large amounts at the time of writing) we may just ask ourselves: What is better for the client?
We need to know a few more things in order to give the answer. a) The loan’s payback begins at the end of the first month. b) Is the interest rate on a declining balance or on the full loan amount? c) is there a forced deposit? d) are there any other fees? The following example may give a clearer picture.
Let’s assume a loan of $1000 at 3% per month and a loan term of 10 months. No forced deposit and no fees.
- With declining balance FINCA will receive $100 principal each month and get $30 interest for the first month. At the end of month 10 we receive $100 principal and $3 interest (because that’s all that was left of the original loan at that time.
- With 25% yearly interest on $1000 the competitor will also receive $100 principal each month and 25% divided by 12 interest on the full amount per month (= $20.83).
So what is better for the customer? How do these methods compare? We need to look at the compounded interest rate payments and calculate the true interest per year, the annual percentage rate (APR).
- needs a spreadsheet to calculate: it turns out to be $172.31 and 20.7% APR
- Total interest paid is $208.33 and APR is 25%
So method 1) from FINCA is cheaper for the customer even though 3% per month may sound like 36% per year. Method 1) is also fairer, as interest is paid on the actual amount in the balance. Method 2) charges the customer $20.83 interest on the residing balance of $100 in the last month. That’s a whopping 20% for just one month!
The Microfinance Transparent Pricing Supervision Handbook by Planet Rating has only one statement to make:
“The declining balance calculation method: the only valid approach”
So FINCA does the right thing. Now the challenge lies in communicating this to the customers. FINCA not only uses the declining balance method but also equal installments. Thus it becomes simple for a client to assess if he or she is able to pay these monthly amounts or not. This could be the single most important factor in loan business. Some of FINCA’s customers are (financially) illiterate. Thus quite some time and training is necessary to make sure all details are understood.
Still there are some customers who maintain that FINCA is expensive. For them spreadsheet calculations can help in comparing the true cost of a loan with a competitor. FINCA doesn’t take additional fees or bribes and has recently stopped requiring a cash deposit of 10% of the loan amount. All these are hidden costs of a loan.
The ones who have decided to get a FINCA credit seem eager when I see them coming to withdraw their loans at the branch. For some of them it is almost too good to be true that they can receive a loan without formal collateral. They are thankful to FINCA and praise its staff for listing to their needs. They can’t wait to put the money to use.
(photo depicts account opening at a remote location so customers don’t need to travel to the branch)