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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
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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
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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
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How did microfinance end up with
non-transparent pricing?
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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
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The Downward Spiral
� All MFIs have transparent
prices� MFI 1:
◦ Interest: 2.5% decl.
� MFI 2:� MFI 2:
◦ Interest: 3.0% decl.
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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
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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
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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
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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
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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%
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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%
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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
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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?
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Average
Price
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Responsible Pricing Range
Too High!
Too
Low!
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Is there a curve in other
countries?
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The interesting question:
Are institutions “off-of-the-
curve” pricing responsibly?
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Why is there a price curve for
micro-loans?
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Cost Components that Affect Pricing
Component
Financial Costs 10%
Loan Loss 2%Loan Loss 2%
Operating Costs 20%
Profit 3%
Total Price 35%
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Realizing that there is a Cost Curve
Efficiency 1 2 3
Operating Cost per
Loan
$50
Loan
Loan Size $500
Operating Cost Ratio 10%
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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%
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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%
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In the Philippines, we find a curve not only for
prices, but also for Operating Costs.
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Common industry benchmark of 15-20%
OpCost Ratio is appropriate for larger loans
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But smaller loans generate an Op Cost
Ratio well in excess of 20%
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Notice that in all three countries there is a
remarkably consistent spread between OCR
and Yield
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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%
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MFI’s Costs
Defining a Responsible Price
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+ MFI’s Choice of Profit
MFI’s Costs
Defining a Responsible Price
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+ MFI’s Choice of Profit
MFI’s Costs
Defining a Responsible Price
= Price Set by the MFI
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+ MFI’s Choice of Profit
MFI’s Costs
Defining a Responsible Price
What Price Can the Poor Afford?
= Price Set by the MFI
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How should we define a
“Transparent Price”?
Total Cost of Credit (TCC)?
Annual Percentage Rate (APR)?Annual Percentage Rate (APR)?
Effective Interest Rate (EIR)?
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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!”
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Which would you buy?
$1 $2$1 $2
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Which would you buy?
$2$1
$2
1 liter 3 liters
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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.
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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
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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%
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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
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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%
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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
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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%
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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.
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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)
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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.
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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.
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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.
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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.
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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%.
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Now for another quiz….
Same loan amounts, same term
and…and…
same interest rate, no fees
(should be easy, right?)
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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%
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You can use our MFT Pricing
Calculator to deepen your
understanding and to calculate actual understanding and to calculate actual
prices of loans
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MFT Pricing Calculation Tool –Advanced Analysis
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MFT Pricing Calculation Tool –Advanced Analysis
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Promoting Transparent Pricing
in the Microfinance Industryin the Microfinance Industry
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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