By Chuck Waterfield,

Microfinance Focus, January 21, 2012: No one can deny that for most micro-loan products in the world, we present the price in confusing and opaque ways. MFTransparency quizzes finance professionals around the world, asking “Which loan would you choose?”   The results are humbling.  First, let’s consider an easy example, where we look at exactly the same loan amount and loan term from four different institutions (1).

It doesn’t look at all clear, so maybe, as do clients, you decide to ask what the total amount you pay back is – what we call the Total Cost of Credit (TCC).  You find out options 1 and 2 both cost R50, Option 3 costs R33, and Option 4 costs R42.  So what do you choose now?   Option 3?  Or is something suspicious going on with that security deposit?

The Annual Percentage Rate (APR) as a measure

When using the Annual Percentage Rate (APR) as a means to calculate the true price, you get some surprising answers, as show in Figure 2.  Options 1, 2, and 3 have nearly identical APRs, and Option 4, which seems to be the highest price, is actually the lowest price.   Even we, who have education and experience in finance, find it challenging to determine the true prices of loans. Why do we think our clients can do any better?

The Downward Spiral and the Transparency Index

We have progressively fallen into the trap we call the “downward spiral”.  MFIs can start out with everyone charging reasonably transparent prices.  A few of the MFIs with the highest prices decide to make their prices less transparent, first switching from declining balance interest to flat interest, then adding fees, and then adding security deposits.  Once a few start, more join them, and in the end it is hard for any MFI to explain why their “high” transparent price is really lower than everyone else’s “low” opaque price.

Notice the bottom line in the previous figure, labeled “Transparency Index”.  This is MFTransparency’s approach to rate the transparency of a price.   We take the annual interest rate as told to the client (e.g. 12%) and compare it to the APR (e.g., 47%), resulting in a score of 32.  A perfectly transparent price, like in Option 4, earns a score of 100.  How transparent are prices?  Of the data we have collected in 28 countries around the world, we find Transparency Indices varying by country.  The most transparent countries have an overall index in the 80’s or low 90’s.  Other countries have indices below 50, meaning that less than half the true price is communicated to the client.

What is the APR, and how is it calculated?

For countries that have established Truth-in-Lending legislation, the process legislated is nearly universally a variant of the APR.  But the APR seems like a mysterious and confusing figure to many clients and even to some of us in the financial industry.  In reality, the APR is an extremely useful and logical concept.  When a client gets a loan, she is not “buying money”.  If she were, the TCC would make more sense.  Instead, she is “renting money”, and the APR is the unit rental charge to rent one unit of currency and keep the full unit for one year.  An APR of 30% means that if I borrow $1.00 and keep the entire $1.00 for 12 months, I pay $0.30 in rental cost, i.e., interest.

The unit rental cost idea is important because few loans allow the client to keep the entire loan balance for the entire loan period.  The client pays back a portion each week or month, and in many cases never even gets the full loan amount disbursed because of fees and security deposits.  Thus, when we tell a client “You can borrow $1,000 for twelve months and the TCC is $160” that does not mean the interest rate is 16%.  The client is making regular principal payments and can have an average balance of $542 over those twelve months.  The declining balance interest rate (and APR) of this example is actually 30%, as the client is paying $160 to rent an average of $542.

When we rent office space, we are told the annual rent (equivalent of the TCC).  However, when shopping around, we generally also ask the “price per square meter” (the equivalent of the APR).  This is a helpful analogy for understanding loan pricing, however loan prices are much more complicated.   Consider how flat interest is calculated – on the original loan amount, not the current balance.   This is like being charged rent of $1000/month for an office of 100 square meters, but every month you have to vacate another 8 meters of space.  In the last month, you would be crammed into just the last remaining 8 meters, but still be paying $1000 for rent.  That certainly makes no sense, but that is precisely how flat interest is calculated.

Can TCC be a near-substitute for APR in some conditions?

Despite the accuracy of the APR, there are many who believe that TCC might be a progressive step toward APR.  Clients gravitate toward “real numbers” like TCC and are confused by abstract percentages like APR.  Therefore, can we use TCC to help clients decide?  The TCC seemed to work for three of the four examples in our simple example.  Can it be used as a simpler alternative for communicating the true price most of the time?

Let’s consider some different examples.   First, when amounts and terms vary, the TCC gets quite difficult to use to compare loans.  Here are three examples with TCC ranging from $240 to $920.  Because of the loan amounts and terms, the $240 is the highest price, and the $920 is the lowest price.  With some basic business sense and a calculator, a client might be able to work through some comparison figure, but the APR would cut straight to the figure they need.

Secondly, there is an underlying assumption that the repayment schedules are identical for loans of the same amount and term.  This may not be true, and those lenders interested in maximizing their portfolio yield can manipulate the product to increase their profit.  Here are three loans, of the same amount and term, and have identical flat-interest rates, no fees, and no security deposits.

Loan 1 uses the technique of “up-front” interest, where interest for the entire loan term is calculated and paid at loan disbursement.  In this example, the client gets only $640 and pays back $1000, rather than getting $1,000 and paying back $1,360.  The MFI gets to use the interest money for the entire term of the loan, and the client has fewer funds during the life of the loan.  Because of the time value of money, the result is a much higher price for the client.

Loan 2 uses flat interest, but provides the client with 3 months of grace at the beginning of the loan.  The irony of flat interest is that the client has the use of more money for more time, i.e., the average balance over the twelve months increases, but the client isn’t charged any additional interest.  The result is a cheaper unit rental price for the client.  Loans with declining balance interest result in the same APR regardless of grace periods because total interest payments increase or decrease correlated to the grace periods.

Loan 3 is a “conventional” loan with flat interest – constant monthly payments, with interest and principal in each payment.  The result is an APR of 61%, somewhere in the middle of the other two loans.   Thus, a Total Cost of Credit of $360 for these three “identical” loans results in APRs ranging from 51% to 91%.

Conclusion

Pricing of products which we buy is relatively straightforward.  Pricing of loans, money which we rent, is more complicated, especially when amounts and terms vary.  As we can see in just these few examples, TCC can give the illusion of transparent pricing and still allow the lender to manipulate the loans to their own advantage.   Truth-in-Lending legislation can level the playing field for all stakeholders.  All lenders are obligated to apply the same rules, thus reducing the temptation to confuse their prices.  All borrowers can then learn that they should ignore the “low price” advertisements on the billboards and instead insist on seeing the official APR.  They then know they are comparing prices properly, and lower means cheaper.

Note: (1) In these examples, “security deposit” is money that is generally marketed to the client as a “savings account”.  The money is unavailable to the client during the loan and returned to the client once the loan is completely repaid.

About the Author: Chuck Waterfield is the Founder and the CEO of MicroFinance Transparency

(Disclaimer: The opinions expressed here are solely those of the author and do not necessarily represent opinion of Microfinance Focus. Microfinance Focus does not take any responsibility for correctness of the data presented by contributors. This article was first published in the Microfinance Focus print magazine which was distributed at the Global Microcredit Summit in Spain)