Transparent Pricing Progress:

Transcription

1 Promoting Transparent Pricing in the Microfinance Industry Transparent Pricing Progress: How to Understand the Prices We Charge SPM Essentials April 2012

2 Agenda 1. Introduction to the confusing world of micro-credit pricing 2. Averages are deceptive in microfinance! 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

3 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% Security deposit: 0% 0% 20% 0% TCC $50 $50 $33 $42 APR 49% 47% 49% 40% Transparency Index

4 How did microfinance end up with non-transparent pricing?

5 The Downward Spiral How did prices get so confusing and nontransparent? It is a combination of: 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

6 The Downward Spiral All MFIs have transparent prices MFI 1: Interest: 2.5% decl. MFI 2: MFI 2: Interest: 3.0% decl.

7 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

8 The Downward Spiral All MFIs have transparent prices Some MFIs shift to flat interest All MFIs shift to nontransparent pricing MFI 1: Interest: 1.75% flat MFI 2: Interest: 2.0% flat

9 The Downward Spiral All MFIs have transparent prices Some MFIs shift to flat interest All MFIs shift to nontransparent pricing.. And it continues MFI 1: Interest: 1.75% flat MFI 2: Interest: 1.6% flat, 2% upfront fee

10 The Downward Spiral All MFIs have transparent prices Some MFIs shift to flat interest All MFIs shift to nontransparent pricing Consumers struggle to choose. Which would YOU choose? MFI 1: Interest: 1.75% flat MFI 2: Interest: 1.6% flat, 2% upfront fee

11 The Downward Spiral All MFIs have transparent prices Some MFIs shift to flat interest All MFIs shift to nontransparent pricing Consumers struggle to choose Because the prices are far from clear MFI 1: Interest: 1.75% flat APR: 37% MFI 2: Interest: 1.6% flat, 2% upfront fee APR: 57%

12 The Downward Spiral All MFIs have transparent prices Some MFIs shift to flat interest All MFIs shift to non- transparent pricing Consumers struggle to choose Profits are correlated to price when loans are identical MFI 1: Interest: 1.75% flat APR: 37% ROE: 10% MFI 2: Interest: 1.6% flat, 2% upfront fee APR: 57% ROE: 40%

13 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 Governments urged to intervene Transparency, and particularly pricing transparency, is a key element to correct this serious problem in the microfinance industry

14 Two common questions without simple answers: 1) What is the market price of microcredit? 2) What is a responsible price for microcredit?

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16 Average Price

17 Too High! Responsible Pricing Range Too Low!

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23 Is there a curve in other countries?

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29 The interesting question: Are institutions off-of-thecurve pricing responsibly?

30 Why is there a price curve for micro-loans?

31 Cost Components that Affect Pricing Component Financial Costs 10% Loan Loss 2% Operating Costs 20% Profit 3% TotalPrice 35%

32 Realizing that there is a Cost Curve Efficiency Operating Costper $50 Loan Loan Size $500 Operating Cost Ratio 10%

33 Realizing that there is a Cost Curve Efficiency Operating Costper $50 $50 Loan Loan Size $500 $250 Operating Cost Ratio 10% 20%

34 Realizing that there is a Cost Curve Efficiency Operating Costper $50 $50 $30 Loan Loan Size $500 $250 $100 Operating Cost Ratio 10% 20% 30%

35 In the Philippines, we find a curve not only for prices, but also for Operating Costs.

36 Common industry benchmark of 15-20% OpCost Ratio is appropriate for larger loans

37 But smaller loans generate an Op Cost Ratio well in excess of 20%

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41 Notice that in all three countries there is a remarkably consistent spread between OCR and Yield

42 Pricing for Different Products Component $100 Loan $1000 Loan Financial Costs 10% 10% Loan Loss 2% 2% Operating Costs 50% 15% Profit 3% 3% TotalPrice 65% 30%

43 Defining a Responsible Price MFI s Costs

44 Defining a Responsible Price MFI s Costs + MFI s Choice of Profit

45 Defining a Responsible Price MFI s Costs + MFI s Choice of Profit = Price Set by the MFI

46 Defining a Responsible Price MFI s Costs + MFI s Choice of Profit = Price Set by the MFI What Price Can the Poor Afford?

47 How should we define a Transparent Price? Total Cost of Credit (TCC)? Annual Percentage Rate (APR)? Effective Interest Rate (EIR)?

48 Total Cost of Credit Isn t Total Cost of Credit sufficient? It s what clients ask for. They don t understand abstract percentages!

49 Which would you buy? $1 $2

50 Which would you buy? $1 $2 1 liter 3liters

51 Prices of loans are much harder. We aren t buyingan item, we are renting money, and we are renting a variable amount of money for a variable amount of time.

52 Which would you buy? Example 1 Loan 1 Loan 2 Amount $1,000 $1,000 Term 12 months 12 months Total Cost $130 $119

53 Which would you buy? Example 1 Loan 1 Loan 2 Amount $1,000 $1,000 Term 12 months 12 months Total Cost $130 $119 APR 24% 22%

54 Which would you buy? Example 2 Loan 1 Loan 2 Amount $1,000 $1,500 Term 12 months 18 months Total Cost $179 $333

55 Which would you buy? Example 2 Loan 1 Loan 2 Amount $1,000 $1,500 Term 12 months 18 months Total Cost $179 $333 APR 33% 28%

56 Now which? Example 3 Loan 1 Loan 2 Amount $2,000 $3,000 Term 6 months 12 months Compulsory Savings 10% 0% Total Cost $245 $568

57 Now which? Example 3 Loan 1 Loan 2 Amount $2,000 $3,000 Term 6 months 12 months Compulsory Savings 10% 0% Total Cost $245 $568 APR 50% 35%

58 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 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.

59 Example of Loan Pricing 1. Interest rate of 3% per month 2. Small closing fee of 2% 3. Savings account with 15% of loan 4. 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)

60 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.

61 With Flat interest, interest is charged on the originalloan 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.

62 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.

63 The red area shows money invested in business. The blue line shows money held in savings. 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%.

64 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%.

65 Now for another quiz. Same loan amounts, same term and same interest rate, no fees (should be easy, right?)

66 Which loan would you pick? Upfront interest can dramatically increase the cost because client haslessmoneyforlesstime 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 Grace periods on flat interest loans can significantly reduce the actual price, because client has moremoneyformoretime 36% p.a. flat Paid monthly 36% p.a. flat Paid monthly Grace period No 3 months grace No Total Cost Credit $360 $360 $360 APR 91% 51% 61% Transparency Index

67 You can use our MFT Pricing Calculator to deepen your understanding and to calculate actual prices of loans

68 MFT Pricing Calculation Tool Advanced Analysis

69 MFT Pricing Calculation Tool Advanced Analysis

70 Promoting Transparent Pricing in the Microfinance Industry

71 Course Announcements Next Sessions: Module 6: Social audit and social rating Monday, April 16 th at 9:30am EDT Tuesday, April 17 th at 9:30am EDT This session recording, presentation, and followup handout will be available here: