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Microcredit Regulatory Authority

Clarification on Interest Rate and other relevant issues of MicrocreditMicrocredit Regulatory Authority has recently issued certain guidelines on interest rate ofmicrocredit. 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 minimumof 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 theyear 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 150divided 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 Principalamount 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 thebanking 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 intoaccount, 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 microcreditsector 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 theInstitutions 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 stilloperate 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.