Microcredit Regulatory Authority

Clarification on Interest Rate and other relevant issues of Microcredit

Microcredit Regulatory Authority has recently issued certain guidelines on interest rate of microcredit. The following are the highlights: 1. Maximum interest chargeable set at 27.00 (twenty seven) percent per annum. 2. Calculation of interest on loans on a Declining Balance Method. 3. Minimum number of installments on general loans must be 50 (fifty). The following clarifications are given for the above issues: In Bangladesh interest on microcredit is calculated on a flat-rate which leads to misunderstanding and confusion about the effective rate of interest. Due to this method of calculation the effective rate of interest charged apparently at 15% goes up to a minimum of 30% which is not clear to many including the clients. Under this method, if a client borrows Taka 1,000 at 15% per annum, the total amount to be paid back at the end of the year is calculated first, which works out to Taka 1,150 (Principal 1,000 + Interest 150). If the MFI recovers this total amount in 50 installments, each installment is calculated to be equal to Taka 23 (Taka 1,000 divided by 50 = Taka 20 against Principal and Taka 150 divided by 50 = Taka 3 against Interest). This in effect means that at the time of repayment of each installment interest is still calculated on the original Principal of Taka 1,000. For example, when repayment is made on the 50th installment, the Principal amount outstanding is only Taka 20, and the interest at 15% per annum should be equal to Taka 0.108 instead of Taka 3 that is charged under the system. This results in the effective rate of interest to increase and go as high as double the original rate, i.e., 30%. In spite of the fact that interest rate is calculated on a declining balance method in the banking sector of Bangladesh, as well as the rest of the world, it is being calculated on the basis of the so called flat rate in the microcredit sector of the country. Effective rate of interest further depends on the grace period, compulsory deductions and charges levied upon the client, and above all, the number of installments. If these factors are taken into account, the effective rate can go beyond twice the original rate (in some cases even up to 37% 46%). It must be kept in mind that the financially disadvantaged client can only benefit from the loan if he is able to generate enough profit to cover for the expenses spent on interest. Only then will he be able to attain the objective of obtaining the loan. Incidentally it may be mentioned that many people are under the mistaken belief that it is not possible to operate profitably as a lender in the microcredit sector through bank borrowings at the existing rate of interest. In reality, the cost of fund for the microcredit sector is only 7% on average compared to 3-4% for the banking sector. It may be noted that the average amount of savings for the MFIs is 30% of the loans outstanding on which only a maximum of 5% interest is paid. Further, the Institutions have a large amount of

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retained earnings, the cost of which is zero. Hence the cost of fund of the microfinance industry works out to 7% taking into consideration the zero cost of retained earnings, cheaper fund from savings along with the traditional cost of bank borrowing. Fixing the maximum chargeable interest rate at 27% would mean that the gross margin for the Institutions would be 20% which is still considered high. The margin is large enough to cater for increased overhead expenses and / or costlier borrowings from banks and still operate profitably. Hence it is possible to further reduce the rate of interest on loans offered by the microcredit institutions through reduced overhead costs, attaining operational efficiency etc. MRA will continue to work to this end in the future.

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