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Transparent

Pricing

Progress:

Promoting Transparent Pricing in the Microfinance Industry

How to Understand

the Prices We

Charge

SPM Essentials

April 2012

Agenda

1. Introduction to the confusing world of micro-credit

pricing

2. Averages are deceptive in microfinance!

3. To understand microfinance, you need to 3. To understand microfinance, you need to

understand “the curve”

4. Transparent pricing is necessary to make the

flawed market of micro-credit function better

Which loan would you pick?Zero Interest

Loan

Interest and

Fees

And Savings Interest

Only

Loan amount: $1,000 $1,000 $1,000 $1,000

Loan term: 10 weeks 10 weeks 10 weeks 10 weeks

Interest Rate: 0% 15% “flat” 12% “flat” 40% decl

Upfront fee: 5% 2% 1% 0%Upfront fee: 5% 2% 1% 0%

Security deposit: 0% 0% 20% 0%

APR 49% 47% 49% 40%

Transparency

Index0 32 25 100

TCC $50 $50 $33 $42

How did microfinance end up with

non-transparent pricing?

The Downward Spiral

� How did prices get so confusing and non-

transparent?

� It is a combination of:

◦ Lack of transparent pricing regulation◦ Lack of transparent pricing regulation

◦ Initial motivation of a small minority to

mask the true price

� The result is a downward spiral drawing in

nearly all MFIs

The Downward Spiral

� All MFIs have transparent

prices� MFI 1:

◦ Interest: 2.5% decl.

� MFI 2:� MFI 2:

◦ Interest: 3.0% decl.

The Downward Spiral

� All MFIs have transparent

prices

� Some MFIs shift to flat

interest

� MFI 1:

◦ Interest: 2.5% decl.

� MFI 2:� MFI 2:

◦ Interest: 2.0% flat

The Downward Spiral

� All MFIs have transparent

prices

� Some MFIs shift to flat

interest

� All MFIs shift to non-

� MFI 1:

◦ Interest: 1.75% flat

� MFI 2:� All MFIs shift to non-

transparent pricing� MFI 2:

◦ Interest: 2.0% flat

The Downward Spiral

� All MFIs have transparent

prices

� Some MFIs shift to flat

interest

� All MFIs shift to non-

� MFI 1:

◦ Interest: 1.75% flat

� MFI 2:� All MFIs shift to non-

transparent pricing.. And

it continues

� MFI 2:

◦ Interest: 1.6% flat, 2%

upfront fee

The Downward Spiral

� All MFIs have transparent

prices

� Some MFIs shift to flat

interest

� All MFIs shift to non-

� MFI 1:

◦ Interest: 1.75% flat

� MFI 2:� All MFIs shift to non-

transparent pricing

� Consumers struggle to

choose…. Which would

YOU choose?

� MFI 2:

◦ Interest: 1.6% flat, 2%

upfront fee

The Downward Spiral

� All MFIs have transparent

prices

� Some MFIs shift to flat

interest

� All MFIs shift to non-

� MFI 1:

◦ Interest: 1.75% flat

◦ APR: 37%

� MFI 2:� All MFIs shift to non-

transparent pricing

� Consumers struggle to

choose… Because the

prices are far from clear

� MFI 2:

◦ Interest: 1.6% flat, 2%

upfront fee

◦ APR: 57%

The Downward Spiral

� All MFIs have transparent

prices

� Some MFIs shift to flat

interest

� All MFIs shift to non-

transparent pricing

� MFI 1:

◦ Interest: 1.75% flat

◦ APR: 37%

◦ ROE: 10%

transparent pricing

� Consumers struggle to

choose

� Profits are correlated to

price when loans are

identical

� MFI 2:

◦ Interest: 1.6% flat, 2%

upfront fee

◦ APR: 57%

◦ ROE: 40%

The Downward Spiral

� Prices are far from clear, and thus:

◦ Consumers over-consume

◦ Market competition is hindered

◦ Strong temptation from high profits

◦ The poor are harmed

◦ Public image is tarnished◦ Public image is tarnished

◦ Governments urged to intervene

� Transparency, and particularly pricing transparency,

is a key element to correct this serious problem in

the microfinance industry

Two common questions without

simple answers:

1) What is the “market price” of 1) What is the “market price” of

microcredit?

2) What is a “responsible price” for

microcredit?

Average

Price

Responsible Pricing Range

Too High!

Too

Low!

Is there a curve in other

countries?

The interesting question:

Are institutions “off-of-the-

curve” pricing responsibly?

Why is there a price curve for

micro-loans?

Cost Components that Affect Pricing

Component

Financial Costs 10%

Loan Loss 2%Loan Loss 2%

Operating Costs 20%

Profit 3%

Total Price 35%

Realizing that there is a Cost Curve

Efficiency 1 2 3

Operating Cost per

Loan

$50

Loan

Loan Size $500

Operating Cost Ratio 10%

Realizing that there is a Cost Curve

Efficiency 1 2 3

Operating Cost per

Loan

$50 $50

Loan

Loan Size $500 $250

Operating Cost Ratio 10% 20%

Realizing that there is a Cost Curve

Efficiency 1 2 3

Operating Cost per

Loan

$50 $50 $30

Loan

Loan Size $500 $250 $100

Operating Cost Ratio 10% 20% 30%

In the Philippines, we find a curve not only for

prices, but also for Operating Costs.

Common industry benchmark of 15-20%

OpCost Ratio is appropriate for larger loans

But smaller loans generate an Op Cost

Ratio well in excess of 20%

Notice that in all three countries there is a

remarkably consistent spread between OCR

and Yield

Pricing for Different Products

Component $100 Loan $1000 Loan

Financial Costs 10% 10%

Loan Loss 2% 2%Loan Loss 2% 2%

Operating Costs 50% 15%

Profit 3% 3%

Total Price 65% 30%

MFI’s Costs

Defining a Responsible Price

+ MFI’s Choice of Profit

MFI’s Costs

Defining a Responsible Price

+ MFI’s Choice of Profit

MFI’s Costs

Defining a Responsible Price

= Price Set by the MFI

+ MFI’s Choice of Profit

MFI’s Costs

Defining a Responsible Price

What Price Can the Poor Afford?

= Price Set by the MFI

How should we define a

“Transparent Price”?

Total Cost of Credit (TCC)?

Annual Percentage Rate (APR)?Annual Percentage Rate (APR)?

Effective Interest Rate (EIR)?

Total Cost of Credit

“Isn’t Total Cost of Credit sufficient? It’s

what clients ask for. They don’t

understand abstract percentages!”understand abstract percentages!”

Which would you buy?

$1 $2$1 $2

Which would you buy?

$2$1

$2

1 liter 3 liters

Prices of loans are much

harder….

We aren’t buying an item, we are renting

money, and we are renting a variable

amount of money for a variable amount

of time.

Which would you buy?Example 1

Loan 1 Loan 2

Amount $1,000 $1,000

Term 12 months 12 monthsTerm 12 months 12 months

Total Cost $130 $119

Which would you buy?Example 1

Loan 1 Loan 2

Amount $1,000 $1,000

Term 12 months 12 monthsTerm 12 months 12 months

Total Cost $130 $119

APR 24% 22%

Which would you buy?Example 2

Loan 1 Loan 2

Amount $1,000 $1,500

Term 12 months 18 monthsTerm 12 months 18 months

Total Cost $179 $333

Which would you buy?Example 2

Loan 1 Loan 2

Amount $1,000 $1,500

Term 12 months 18 monthsTerm 12 months 18 months

Total Cost $179 $333

APR 33% 28%

Now which?Example 3

Loan 1 Loan 2

Amount $2,000 $3,000

Term 6 months 12 monthsTerm 6 months 12 months

Compulsory

Savings10% 0%

Total Cost $245 $568

Loan 1 Loan 2

Amount $2,000 $3,000

Term 6 months 12 months

Now which?Example 3

Term 6 months 12 months

Compulsory

Savings10% 0%

Total Cost $245 $568

APR 50% 35%

What is the APR?(Annual Percentage Rate)

The APR indicates the cost for you to borrow $1.00

for one year. It is a unit rental cost.

An APR of 30% means it would cost you 30 cents to An APR of 30% means it would cost you 30 cents to

borrow $1.00 and keep the entire $1.00 for one full

year.

The APR is an essential figure for you to compare the

true cost of different loans.

Example of Loan Pricing

1. Interest rate of 3% per month

2. Small closing fee of 2%

3. Savings account with 15% of loan

We pay you 5% interest on your savings4. We pay you 5% interest on your savings

What do you think the APR of this loan is?

(we will calculate APR without compounding, i.e, using the US

formula, not including compounding, as with the EU

formula)

Declining Balance interest reflects the textbook definition of interest as a charge for the

use of money over time. APR is equivalent to declining balance interest with no fees.

With “Flat” interest, interest is charged on the original loan amount resulting in nearly

double the cost of declining balance interest. Why double? The area of the rectangle

under the green line is almost double the area under the red stair-step loan balance.

In addition, the client is often charged fees for the loan. In this example, a 2% up-front fee,

because of the short loan term, surprisingly adds 13% to the APR. A loan advertised as 36%

interest is now the equivalent of 78% APR.

The red area shows money

invested in business.

Compulsory savings adds to the cost. Clients are charged interest on the original loan ($1000)

even though they never have use of that amount. In this example, the APR is now 107%.

The blue line shows money held in savings.

Clients are paid interest, but significantly less interest on their savings than they are charged on

their loans. When earning 5% interest, the APR only drops from 107% to 105%.

Now for another quiz….

Same loan amounts, same term

and…and…

same interest rate, no fees

(should be easy, right?)

Which loan would you pick?Loan 1 Loan 2 Loan 3

Loan amount: S1,000 $1,000 $1,000

Loan term: 12 months 12 months 12 months

Interest Rate: 36% p.a. “flat”

Paid upfront

36% p.a. “flat”

Paid monthly

36% p.a. “flat”

Paid monthly

Grace period No 3 months grace No

Upfront interest can dramatically

increase the cost because client

has less money for less time

Grace periods on “flat interest”

loans can significantly reduce the

actual price, because client has

more money for more time

Grace period No 3 months grace No

Total Cost Credit $360 $360 $360

Transparency Index 39 71 59

APR 91% 51% 61%

You can use our MFT Pricing

Calculator to deepen your

understanding and to calculate actual understanding and to calculate actual

prices of loans

MFT Pricing Calculation Tool –Advanced Analysis

MFT Pricing Calculation Tool –Advanced Analysis

Promoting Transparent Pricing

in the Microfinance Industryin the Microfinance Industry

Course AnnouncementsNext Sessions:

Module 6: Social audit and social rating

Monday, April 16th at 9:30am EDT

Tuesday, April 17th at 9:30am EDTTuesday, April 17th at 9:30am EDT

This session recording, presentation, and follow-up handout will be available here:

http://sptf.info/sp-task-force/online-trainings