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Interest Rates and Self-Sufficiency

LESSON 1

THE ROLE OF INTEREST RATES

and Self-Sufficiency LESSON 1 THE ROLE OF INTEREST RATES Interest is the amount paid by a

Interest is the amount paid by a borrower to a lender in exchange for the use of the lender's money for a certain period of time.

Money is a scarce resource. There is a limited amount of it, and it has value for everyone. Interest represents the cost of money — what a borrower pays in order to rent money for a certain period of time. Interest rates help determine the allocation of money because, as with other goods in the economy, the demand for money is influenced by its cost.

Interest does more than determine the allocation of money; it provides income to lenders. Interest is a cost paid by borrowers that enables lenders to provide an efficient lending service and to generate a reasonable profit. For microenterprise credit institutions, interest income determines whether the institution is dependent on donor funds or able to maintain itself with its own earned income.

For entrepreneurs who borrow, interest rates provide a "hurdle rate" over which investments must pass to be a valid use of scarce resources. If it costs an entrepreneur 9 percent to borrow $1,000 for a year, then the investment must earn more than $1,090 to be potentially worthwhile. Investments that earn 9 percent or less are inefficient uses of scarce financial resources.

In short, interest rates on loans are critical to borrowers, lenders, and the economy as a whole. The establishment of appropriate interest rates is crucial for the effective operation and financial management of microenterprise finance institutions.

Interest Rates from Two Perspectives

A. The Borrower's Perspective

Financial Costs are the interest and fees that borrowers pay to lenders in order to use the money for a specific period of time.

Transaction costs are indirect costs incurred to obtain loans.

Because transaction costs do not benefit either the lender or the borrower, lenders should minimize them to the greatest extent possible.

When a borrower approaches a lender for a loan, he is confronted with two different types of costs. The most obvious cost is the actual cost of the money, including the interest to be paid for the use of the loan, and the fees paid to the lender for processing and disbursing the loan. These costs are the financial costs of the loan.

Interest rates and self sufficiency

The borrower must also pay transaction costs. Transaction costs are indirect costs incurred to obtain loans. They include bus fares to the lender's place of business, the cost of obtaining documents (like financial statements) required for the loan, the cost of the time spent by the borrower fulfilling the requirements for the loan, and any other costs related

to acquiring the loan. Transaction costs also include costs due to inefficiencies in lender

delivery systems, such as missed investment opportunities because of delays in loan disbursement; the extra time spent processing a loan because the lending institution misplaces a document, and others. Transaction costs are often greater than the financial costs if lenders are inefficient in their loan approval or disbursal process.

Financial and transaction costs represent the total borrowing costs of a loan. Because transaction costs do not benefit either the lender or the borrower, lenders should minimize them to the greatest extent possible. Financial costs, on the other hand, provide income

to the lender in the form of interest and fees.

make it easier for their borrowers to afford higher financial costs. Financial costs should be established carefully by the lending institution in order to generate the income that the

institution needs for survival and growth.

Lenders that minimize transaction costs

Given a fixed level of transaction costs, what level of financial costs can micro

entrepreneurs afford to pay? How much in interest and fees can micro entrepreneurs pay and still benefit from borrowing money? These are controversial questions, and the source

of continual debate in the micro enterprise credit field. The response depends on the

profitability of the enterprises in question.

A financial analysis of microenterprises will usually show the activities to be quite

profitable, enabling the entrepreneurs to pay financial costs equivalent to or higher than

"commercial" rates 1 and still benefit from the loans. In some cases, however, when the level of profitability is extremely low, financial costs near commercial levels may represent an unbearable burden for certain activities. In such cases, loans may be an inappropriate intervention, and alternative mechanisms to promote economic development should be investigated.

B. The Lender's Perspective

There are three basic costs that lending institutions must cover with their income: the financial cost of the funds in their portfolio, known as the cost of funds, the cost of maintaining a loan loss reserve so that the portfolio does not decapitalize when loans are defaulted, and other operating costs that include the salaries of staff, rent, and other operating expenses.

To be self-sufficient, a financial institution must cover the above costs with income generated by financial services. For microenterprise credit institutions, interest charged on loans and fees associated with lending are the primary sources of earned income. The loan portfolio (funds lent to borrowers and funds on deposit available to be lent) produces a gross rate of return, or yield, which is the interest and fee income divided by the average

portfolio. Self-sufficient lending institutions have a rate of return high enough to cover all

of

their costs, and keep the value of their funds from deteriorating because of the effects

of

inflation.

1 Commercial rates refer to the interest rates charged by commercial banks for small enterprise of similar loans.

Interest rates and self sufficiency

The diagram below shows the flow of cash for borrowers and lenders during a loan transaction. What the borrower pays in financial costs becomes the lender's income, which is used to pay for expenses. What the borrower pays in transaction costs is lost to both the borrower and the lender. The loan principal goes back and forth between the borrower and the lender.

Figure 1

CASH FLOW OF LENDING TRANSACTIONS FINANCIAL COSTS: • Interest • Fees INCOME
CASH FLOW OF LENDING TRANSACTIONS
FINANCIAL COSTS:
• Interest
• Fees
INCOME

BORROWERS

FINANCIAL COSTS: • Interest • Fees INCOME BORROWERS Transaction costs LENDER Cost of funds Loan loss

Transaction

costs

LENDER

Cost of funds Loan loss reserve Operational costs

INCOME BORROWERS Transaction costs LENDER Cost of funds Loan loss reserve Operational costs Loan Principal ACCION

Loan

INCOME BORROWERS Transaction costs LENDER Cost of funds Loan loss reserve Operational costs Loan Principal ACCION

Principal

Interest Rates and Self-Sufficiency

LESSON 2

Interest Rates and Self-Sufficiency LESSON 2 NOMINAL, EFFECTIVE AND REAL INTEREST RATES Understanding interest rates for

NOMINAL, EFFECTIVE AND REAL INTEREST RATES

Understanding interest rates for microenterprise lending requires knowledge of a few financial terms, concepts, and formulas. This lesson discusses basic types of interest rates and their methods of calculation.

Interest Rates and Their Uses

Rate

Definition

Use

Nominal

Quoted rate of interest on a loan.

To calculate interest due on a loan.

Effective

Actual rate that borrower pays for a loan, including interest, fees, and commissions.

To determine and compare total financial cost of loans.

Real

Either the nominal or effective rate adjusted to compensate for inflation.

To determine whether the effective or nominal rate charged is sufficient to compensate for devaluation of the loan fund due to inflation.

Nominal Rates of Interest

Nominal rates of interest on a loan are the rates the lender states the borrower will pay. Most financial institutions quote nominal rates on an annual basis. Because microenterprise loans frequently have terms of less than a year, nominal interest rates are often quoted on a monthly basis.

Nominal interest rates are used to calculate the amount of interest to be paid on a loan. The amount of interest to be paid for a loan depends on the nominal interest rate, the amount borrowed, and the time period. For example, a loan of $1,000 to be repaid in one year at 9 percent annual interest would mean that the borrower pays back the $1,000 in principal at the end of one year, plus $90 in interest (1,000 x .09 x 1 year). Because this loan is paid back in one payment of principal and interest, the interest calculation is referred to as simple interest.

Amortized Loans

Most microenterprise loans are instalment or amortized loans, however, meaning that equal, periodic (such as weekly or monthly) payments of principal and interest are made throughout the life of the loan. To figure out the interest payments for amortized loans, the nominal interest rate is multiplied by the amount of principal outstanding (the declining balance) for each payment period.

Interest rates and self sufficiency

Amortized loans are paid in equal, periodic payments of principal and interest over the life of the loan.

AMORTIZATION SCHEDULE

The following amortization schedule shows the payments to be made on a three-month, $100 loan with a nominal interest rate of 2 percent per month. Lesson 4 shows how nominal interest rates are used to calculate the monthly payment amount and construct the amortization schedule.

Example 1

Month

Interest payments

Principal

Total Payments

Balance

 

$

Payments ($)

($)

($)

       

100.00

1

(100.00 x 0.02)= $2.00

+ 32.68

=

34.68

67.32

2

(67.32 x 0.02) = $1.35

+ 33.33

=

34.68

33.99

3

(33.99 x 0.02) = $0.68

+ 33.99

=

34.68

0.00

 

Total

$4.03

+ 100.00

=

104.03

 

Although nominal rates are quoted by financial institutions, in most cases they do not accurately portray the financial costs of a loan. What if the loan described above carries a 3 percent commission in addition to the 2 percent interest charge? Or, what if the lender calculates the interest payments each month by multiplying the nominal interest rate times the original loan amount instead of times the outstanding balance?

In these cases, the borrower pays more than 2 percent for the loan. In other words, the borrower effectively pays a rate higher than the nominal interest rate. When the borrower pays a rate different from the nominal interest rate, then the effective interest rate must be calculated to figure out the actual financial costs of the loan.

INTEREST ON THE ORIGINAL LOAN AMOUNT

Using the original loan amount (sometimes referred to as flat interest), the amount of interest that the borrower pays during each payment period equals the nominal interest rate times the original loan amount, no matter what the outstanding balance of the loan is during the period.

Example 2

Month

Interest payments

Principal

Total Payments

Balance

 

$

Payments ($)

($)

($)

       

100.00

1

(100.00 x 0.02)= $2.00

+ 33.33

=

35.33

66.67

2

(100.00 x 0.02)= $2.00

+ 33.33

=

35.33

33.34

3

(100.00 x 0.02)= $2.00

+ 33.34

=

35.34

0.00

 

Total

$6.00

+ 100.00

=

106.00

 

Interest rates and self sufficiency

For each payment, the borrower pays 2 percent of the original loan amount ($100) in interest, and one-third of the original loan amount in principal. The borrower pays $6 in interest for this loan, compared to $4.03 when interest was calculated on the declining

balance.

Charging flat interest means that the borrower pays interest on the original loan amount ($100) for three months, even though he owes substantially less than $100 of principal for two of those months. As the loan term lengthens, the interest costs of flat interest loans become far greater than for loans calculated using the declining balance, and the rate actually paid becomes far higher than the nominal interest rate.

Some microenterprise credit programs use flat interest because it facilitates the calculation of the amortization schedule, is easy for borrowers to understand, and the program earns more than its quoted nominal interest rate. Flat interest calculations are generally not considered acceptable for formal financial institutions, however, as they are considered misleading to the borrower.

Effective Rates of Interest

Effective interest rates show the ratio of the total financial costs of a loan, considering interest, fees and the calculation method, to the principal amount that the borrower uses.

Effective rates of interest bring all of the direct financial costs of a loan together in one interest rate. Effective interest rates incorporate interest, fees, the calculation method, and other loan requirements into the financial cost of the loan. Effective rates can be compared to determine whether the conditions of one loan make it more expensive or less expensive to the borrower than the conditions of another loan.

When interest is calculated on a declining balance, and there are no additional costs to a loan (as in the example in Example 1), the effective interest rate is the same as the nominal interest rate. Most financial institutions, however, use an interest rate and fee structure that make the effective interest rate on their loans higher than their nominal rate. Their reasoning may be a desire to have lower nominal interest rates, a strategy to cover the costs of a specific service (such as loan monitoring) with a specific fee, or a system for generating income upon loan disbursal.

Effective interest rates will differ from nominal rates whenever a different method of calculation is used, or there are additional financial costs, such as:

a. The interest being calculated based on the original loan amount instead of the outstanding balance.

This flat method of calculation is commonly used by informal lenders and some microenterprise credit programs. The effective monthly interest rate of the loan in Example 2 is not the stated nominal rate of 2 percent, but 2.97 percent. The borrower pays $6 in interest instead of $4.03. As the loan term increases, the effective rate of loans calculated with flat interest becomes increasingly larger than the nominal rate.

b. The interest being deducted ("discounted") from the original loan amount before the loan is disbursed.

For a three-month, $100 loan at 2 percent, the borrower pays a total of $4.03 in interest (as in Example 1). That $4.03 is deducted from the amount the borrower receives. The borrower receives $95.97, but pays interest on the entire $100. The

Interest rates and self sufficiency

monthly effective interest rate is 2.08 percent, even though the nominal rate is 2 percent. The effective interest rate on discounted loans becomes increasingly larger than the nominal rate as the loan term increases.

c. A commission or other fee.

Fees will alter the effective interest rate to varying degrees depending on how they are calculated and paid. For example, if the bank charges a 5 percent fee on the loan in Example 1, payable upon loan disbursal, then the borrower receives a $100 loan, but has to pay $5 right away. The borrower pays interest on $100, but only gets to use $95. The effective monthly interest rate on the loan is 4.68 percent, more than double the nominal rate of 2 percent. Unlike the previous cases, the effective interest rate on loans with fees decreases as the loan term increases, because the cost of those fees is spread out over more payment periods.

d. A requirement that the borrower maintain a minimum amount, a compensating balance, in a savings account in order to receive a loan.

Compensating balances arc a common practice of credit unions and some microenterprise programs. The borrower in Example 1 might be required to place $25 on deposit in a savings account to receive a loan for $100. Effectively, the borrower receives a $100 loan, pays interest on $100, but has $25 of his own money tied up without being able to use it to generate income. The monthly effective interest rate is 4.3 percent.

The higher the effective interest rate, the more this loan is actually costing the borrower, and the more it is earning the lender.

As the examples above show, a three-month loan advertised at 2 percent monthly interest can have an effective interest rate considerably higher than 2 percent. The higher the effective interest rate, the more this loan is actually costing the borrower, and the more it is earning the lender. All of these types of interest calculations are used, underscoring how little nominal interest rates reveal about the costs of a loan. The only way to ascertain the true financial costs of loans and compare the costs of loans from different lenders is by using the effective interest rate.

Calculating Effective Interest Rates

The effective interest rate represents the total financial cost of a loan to the borrower, considering the conditions of the loan (as in the four examples above). For loans with only one payment at the end, simple interest loans, calculating the effective interest rate is easy. The effective interest rate is the amount the borrower pays in interest, fees, and commissions, divided by the amount the borrower receives.

Effective Interest Rate

=

amount paid in interest, fees and commissions principal amount received by borrower

For example, the effective interest rate (EIR) of a $100 simple interest loan at 2 percent per month, with a 5 percent fee paid upon loan disbursal, is:

EIR

=

($100x0.06 interest) + ($100 x 0.05 fee) ($100 - $5 fee)

=

11.6% for three months or 3.9% per month

Interest rates and self sufficiency

Calculating the effective interest rate for amortized loans is more complicated because the amount on which the interest payments are calculated (the amount of principal outstanding) is different for each payment period. A rough approximation of the effective interest rate can be calculated by dividing the interest, fees, and commissions on the loan by the sum of the amounts outstanding during the loan period. The result is the effective interest rate per payment period.

EIR

=

amount paid in interest, fees and commissions sum of principal amounts outstanding

For example an approximation of the effective interest rate of a $100 amortized loan with monthly payments, a monthly nominal interest rate of 2 percent and a 5 percent commission paid upon loan disbursal is:

EIR

=

4.03 interest 1 + (0.05 x 100 fee) (100 + 66.67 + 33.34)

EIR = 4.5% per month.

1 See Example 1 for calculation of amount of interest

The easiest way to accurately calculate effective interest rates, however, is to use a spreadsheet. The spreadsheet can be set up to calculate the effective rate when provided with the amount the borrower receives (sometimes called present value [PV]), the number of payment periods (N), and the amount to be paid in each period (PMT, often entered as a negative number). These three variables change depending upon the conditions of the loan. The following example shows how these variables are used to determine the effective interest rate of an amortized loan with a commission.

Example 3:

USING A SPREADSHEET TO CALCULATE EFFECTIVE INTEREST RATES

To calculate the effective interest rate of a $100, 3-month loan with a nominal interest rate of 2 percent per month and a commission of 5 percent paid upon loan disbursement:

1. Determine the monthly payment:

a) Enter into the spreadsheet the loan amount, the number of payment periods and the nominal monthly interest rate:

PV

=

100

N

=

3

i

=

2

b) Solve for payment: PMT = -34.68.

2. Determine the effective interest rate:

a) Enter into the spreadsheet the monthly payment, the amount the borrower effectively received and the number of payment periods:

PMT = -34.68

PV

=

95 ($100 minus 5% of $100)

N

=

3

b) Solve for effective interest rate:

i = 4.7% (per month).

Interest rates and self sufficiency

Lesson 4 shows how to use a spreadsheet for loans with flat interest, interest deducted up front, and compensating balances. A spreadsheet is attached to this study guide, which you can use to make these calculations.

It is important to realize that the effective interest rates of loans with the same nominal interest rate and fee can vary with the loan size and loan term. A three-month, $100 loan at 2 percent per month, with a 5 percent fee paid up front, has an effective rate of interest of 4.7 percent per month (see above for calculation). The same loan over a six month period has an effective rate of 3.5 percent per month. If the fee is a set amount, instead of a percentage of the loan amount, then the effective rate will change considerably as the size of the loan increases or decreases as well.

Real Rates of Interest

The real rate of interest is the rate of interest adjusted to allow for inflation and is the interest rate minus the rate of inflation.

Real rates of interest are rates that have been adjusted to compensate for the effects of inflation. Real interest rates are either nominal or effective rates of interest minus the inflation rate. They can be either positive or negative. For instance, if an institution charges an effective rate of 45 percent annually in an economy where inflation is 24 percent a year, then the real effective rate of interest is 21 percent (45 - 24). If only 20 percent interest is charged, then the real effective rate is negative 4 percent. Real rates of interest are important analytical tools for managers who must ensure that they do not let inflation eat away the value of their lending portfolios. With negative-real rates of interest, the value of a loan portfolio cannot be maintained.

THE EFFECTS OF INFLATION

The effects of inflation on the value of a portfolio can be calculated with the following formula, where VP f is the value of the portfolio at the end of the period, VP i the value of the portfolio at the beginning of the period, and i the rate of inflation of the period:

VP f =

VP i

(1+i)

In Colombia, during the period from 1980 to 1988, the average annual rate of inflation was 24 percent. If a credit program had a portfolio in Colombian pesos worth US$ 100,000 in 1985, and neither lost nor added any new money to the portfolio through 1987, then the change in value of the portfolio during the three-year period would have been:

Year

Value of Beginning Portfolio ($)

Value of Ending Portfolio ($)

Value Lost to Inflation ($)

1985

100,000

80,645

19,353

1986

80,645

65,036

15,609

1987

65,036

52,488

12,588

By 1988, the pesos in the portfolio would have been worth only $52,448! To preserve the value of its portfolio, the program would have to generate enough income to add the amount shown in the "Value Lost to Inflation" column to its portfolio each year. In 1985,

Interest rates and self sufficiency

approximately 20 percent (19,355/100,000 = 19.4 percent) interest would have to be earned on the portfolio just to replace the value lost that year.

Negative real interest rates are common in highly inflationary environments, especially if government policies control interest rates. Negative rates create great incentives to borrow because, in effect, the borrower pays back less (in value) than what he borrowed.

Subtracting the inflation rate from the interest rate produces an approximation of the real interest rate. As inflation increases, however, this approximation becomes less accurate and the following formula should be used:

real interest rate = (1 + nominal interest rate) (1 + inflation rate)

- 1

In order to control the negative effects that high rates of inflation can have on financial systems, some countries index loans. The loans are not denominated in a specific currency, like pesos, but rather in a non monetary unit that is pegged to inflation. This non monetary unit, such as the unidad de poder adquisitivo constante in Colombia (UPAC:

constant purchasing unit) is a "value unit" pegged to a specified "basket" of goods and services that is used to measure inflation. The UPAC is, in essence, a monetary unit that reflects inflation. In Colombia, interest rates for long-term loans (mostly for housing) are always expressed as UPACs plus a nominal interest rate.

Interest Rates and Self-Sufficiency

LESSON 3

Interest Rates and Self-Sufficiency LESSON 3 ESTABLISHING INTEREST RATES FOR SELF-SUFFICIENCY Self-sufficient financial

ESTABLISHING INTEREST RATES FOR SELF-SUFFICIENCY

Self-sufficient financial institutions need to design an interest rate and fee structure that generate enough income to cover their costs. There are two sides to this self-sufficiency equation, the cost side and the income side. For an institution to be self-sufficient, its income has to be greater than or equal to its costs. For microenterprise finance institutions, income is earned through interest on portfolio funds (whether in the hands of borrowers or on deposit), and through fees or commissions. 1 Costs include the cost of funds, loan loss reserve, and other operational costs.

This same equation can be expressed with relation to the institution's portfolio. Annual income divided by the average outstanding portfolio during the year indicates the percent yield of the portfolio, or the rate of return on the portfolio. For an institution to be self-sufficient, the yield of its portfolio must be greater than or equal to the sum of its costs during the year divided by the average outstanding.

Accurately predicting the costs and income of a financial institution is a difficult task that requires the use of financial projections. 2 This section presents a conceptual guide to defining an appropriate interest rate and should be used with financial projections to determine a precise interest rate and fee structure.

The Cost Side of the Equation

There are three types of costs that a self-sufficient financial institution needs to cover with its income: the cost of funds, the cost of maintaining a loan loss reserve, and operating costs. These costs are the basic building blocks for determining how much an institution needs to earn to be self-sufficient. When these costs are expressed as a percentage of a given portfolio, they reflect the minimum rate of return, or yield, the portfolio must generate for the institution to cover all of its costs.

COSTS OF FINANCIAL INSTITUTIONS

Cost

Description

Cost of funds

Direct costs of resources used in loan portfolio; includes financial costs of borrowed funds. Also includes the "cost" of inflation on the institution's own funds.

Loan loss reserve

Amount of income needed to be set aside to maintain the loan loss reserve which is reduced when loans are written off.

Operating costs

Cost of other operating expenses.

1 Institutions may have income from other sources but this discussion focuses on an institution's credit operation and the self sufficiency of those operations.

2 Detailed projections require the use of a spreadsheet such as Microfin – see www.microfin.com

Interest rates and self sufficiency

Cost of Funds

The cost of funds is what lending institutions pay for the resources they use to lend to their borrowers.

The cost of funds refers to the amount institutions pay for the resources they use to lend to their borrowers. These resources may be loans from local banks, savings deposited by borrowers, retained earnings of the institution, donated funds, or other funds in the portfolio.

Traditionally, most microenterprise credit programs have begun operations with donations, which have close to zero costs (the time and expense of applying for the funds is a cost). In order to expand, however, an increasing number of microenterprise institutions are borrowing funds at both subsidized and commercial rates of interest. Like any borrower, the microenterprise institution must pay financial costs for the funds it borrows for its portfolio. These costs include interest paid to depositors (if the institution accepts savings deposits), interest paid to lenders, fees paid to lenders (or donors), compensating balances required by lenders or donors, and any other financial costs.

The portion of an institution's portfolio funds that is not borrowed, but was donated or earned by the institution (or invested in it), form part of its equity. Though it pays no interest on these funds, the institution should protect them from devaluation due to inflation. One way to preserve the value of equity funds in the portfolio is to consider that they have a cost equal to the expected rate of inflation. 3 Interest is then charged to cover that cost, and the income generated is reinvested in the portfolio to preserve its real value.

The institution does not have to preserve the value of the money it has borrowed from a bank or other source for its portfolio. The bank should charge the institution sufficient interest to preserve the value of those funds. If the bank does not charge sufficient interest, then the institution pays the bank back less (in value) than it borrowed; a situation that benefits the institution to the detriment of the bank.

In sum, the cost of funds includes the effective rate of interest on all borrowed money. It also includes the "cost" of inflation on the institution's own funds.

Loan Loss Reserve

Credit institutions must earn enough income to replace funds lost from the portfolio because of loan defaults. The loan loss reserve is established from income earned by the institution and is used to replenish funds lost to the portfolio when loans are written off. Through this process, non-recoverable amounts lost from the portfolio are replaced by income earned by the institution, thereby preventing the decapitalization of the portfolio.

Normally, financial institutions estimate the amount of expected bad debt (on the basis of prior experience and estimated potential losses from the current portfolio), and express it as a percentage of the portfolio. Mature financial institutions can usually predict with a high degree of accuracy the amount that will not be recovered and that should be in the loan loss reserve. As a general role, well-managed microenterprise credit institutions should not have loan losses exceeding 3 percent of the average portfolio in any given year. With estimated annual losses of 3 percent of the average portfolio, an institution's loan loss reserve should be maintained at 3 percent of the portfolio, and the interest rate charged to borrowers should include 3 percent to maintain that reserve.

3 Estimating future inflation rates is extremely difficult. Estimates calculated by a country's Central Bank or another reliable source can be used.

Interest rates and self sufficiency

Operating Costs

The operating costs of a credit institution include salaries, rent, supplies, and all other costs of operation. Because institutions in their early phases of operation have relatively high costs in relation to their small start-up portfolio, they must estimate their operating costs as a percentage of an expected future portfolio. Earning that percentage on the expected future portfolio will generate enough income for the institution to pay its operating costs. Until the institution reaches the expected future portfolio and its break- even point the operating deficit will have to be covered from a source other than the income earned on loans.

Because most microenterprise credit programs operate in an environment with little direct competition, they must challenge themselves to control their costs, provide efficient service, and become self-sufficient.

One cautionary note about covering costs is in order. A credit institution's costs (especially operating costs and those related to maintaining a loan loss reserve) will depend to a large degree on its efficiency. Borrowers should not have to pay high interest rates to cover a program's inefficiencies. Because most microenterprise credit programs operate in an environment with little direct competition, they must challenge themselves to control their costs, provide efficient service, and become self-sufficient. Some of the larger and most efficient microenterprise finance institutions have operating costs of approximately 15 percent of the principal amount outstanding.

In sum, a self-sufficient financial institution needs to earn enough income to pay its cost of funds, maintain a loan loss reserve, and pay for its operating costs. Accurately predicting these costs requires financial projections. By examining the sum of these costs in relation to a given portfolio size, an institution can determine the rate of return or yield that the institution must earn on its portfolio to break even. Example 1 shows how a non-profit lending institution can use these concepts to determine the rate of return that it needs to earn to cover its costs in a given year.

EXAMPLE 1

DETERMINING THE NEEDED RATE OF RETURN

A. Conditions

 

Estimated rate of inflation for year

18

%

Own funds in portfolio

$500,000

Borrowed funds in portfolio

$300,000

Total portfolio

$800,000

Effective interest rate on borrowed portion of portfolio:

15

%

Estimated annual loan loss rate (based on experience):

3 %

Operating costs as a percentage of $800,000 portfolio:

22

%

(With an annual income of $176,000, or 22 percent of $800,000, the institution covers its annual operating costs.)

 

Interest rates and self sufficiency

B. Calculation

The institution wants to preserve the value of its own funds ($500,000, or 63 percent of portfolio) and has made a policy decision to assign a cost to those funds equal to the estimated rate of inflation (18 percent). Revenues generated by assigning a cost of 18 percent to those funds will be reinvested in the portfolio to preserve its value.

Consequently, 63 percent of the portfolio has a cost of 18 percent, and 37 percent (the borrowed portion) of the portfolio has a cost of 15 percent.

The total cost of funds is:

(.63) (.18) + (.37) (.15) = .1689, or

17

%

The estimated loan loss is:

3 %

The operating margin or spread is:

22

%

The sum of these three components is:

42

%

If the institution has accurately projected its costs, and earns 42 percent on its portfolio of $800,000, it will cover all of its costs and break even.

The Income Side of the Equation

If the lending institution in Example 1 earns 42 percent on its portfolio, assuming its cost estimates are correct, it will be self sufficient. In the simplest of worlds, that institution could charge 42 percent interest for its loans and break even. Unfortunately, charging 42 percent is unlikely to be the best solution.

Even though an institution's financial projections might indicate that it needs to earn 42 percent on its portfolio in order to be self-sufficient, and micro entrepreneurs are willing and able to pay an effective rate of 42 percent or more, there may be external constraints that hinder the institution's ability to charge that rate. These constraints could be the result of government policies, laws, donor policies, or even other local institutions providing credit to micro entrepreneurs.

If interest rate ceilings or other regulations apply to nominal rates of interest, then they are not very restrictive. Banks commonly quote a nominal rate to which considerable commissions and fees are added. To avoid or limit controversy, microenterprise credit institutions can adopt a similar policy. Instead of charging 42 percent annual interest, the institution could set its nominal interest rate at 27 percent, and then charge the equivalent of 15 percent in commissions and fees for orientation sessions, application costs, and loan monitoring. In this way, the nominal interest rate might be similar to the nominal rates charged by banks, and considerable unnecessary controversy might be avoided.

Even if the institution does charge an effective rate of 42 percent, however, the portfolio is unlikely to generate the 42 percent yield needed. Two key factors of credit operations make the rate actually earned on a portfolio different from the effective rate being charged. Those factors are on-time repayment rates below 100 percent and idle funds.

Even if the institution does charge an effective rate of 42 percent, however, the portfolio is unlikely to generate the 42 percent yield needed.

Interest rates and self sufficiency

The Effect of Loan Terms on Income

As discussed in the section on effective interest rates, loans with commissions or fees will have higher effective interest rates as the loan term decreases. Likewise, a lending institution that charges fees will earn more income the shorter the terms of its loans, as the same portfolio amount generates fees more frequently.

Assume that the institution with an $800,000 portfolio charges 27 percent interest and 20 percent of the loan amount as an up-front fee. There is no delinquency and the money is re-lent the same day it is paid.

With an average loan term of 12 months, the yearly income is:

$376,000 [(800,000 x 0.27) + (800,000 x 0.20)]

If

the average term is 6 months, annual income increases to:

$536,000 [(800,000 x 0.27) + (1,600,000 x 0.20)]

If

the institution charged 47 percent interest and no fees, its annual income regardless

of the loan term, would be:

$376,000 (800,000 X 0.47)

Repayment Rates

Late payments can have a devastating effect on an institution's income. The cost side of the self-sufficiency equation includes the cost of default through the maintenance of a loss reserve. In addition, the side of the equation must incorporate the interest income postponed from loans that fall into arrears (some of which might eventually be lost if the loans are defaulted). If interest payments on loans are not made when they are due, interest income during a specific period will be far lower than the amount outstanding times the nominal interest rate for that period.

One common method used by financial institutions to compensate for income postponed due to delinquency is to charge a penalty for late payments. Such penalties also serve to motivate on-time repayment.

Effect of Late Payments on Interest Income

The institution in Example 1 calculates that it needs to earn 42 percent on its portfolio of $800,000 to break even in a given year. The nominal interest rate is 27 percent, and the rest is through fees collected upon loan disbursal.

Assume that only 90 percent of the amount due during the year (principal and interest) is actually paid during the year.

Instead of earning 27 percent in interest on the portfolio during the year, i.e. $216,000, the program earns only 24 percent (0.90 x 0.27), i.e. $194,400 (0.90 x 0.27

x 800,000).

Interest rates and self sufficiency

Idle Cash

Efficient portfolio management is critical for an institution to maximize its income. Money in the hands of borrowers should produce more income than cash on hand, money on deposit in the bank, or funds in other low risk investments. Money that is not generating income is considered "idle". All financial institutions will have varying amounts of funds throughout the year that are either idle or earning lower rates of interest than they would be if they had been lent out to borrowers. These are funds that are between loans (paid back but not yet lent out again), or not lent out because of a lull in demand or a pending expansion.

To maximize income and meet the credit needs of micro entrepreneurs, credit institutions need to minimize idle funds, maintain available portfolio funds in the hands of borrowers to the greatest extent possible, and look for secure high-yielding investments when there are excess funds.

Effect of Idle Funds on Income

Assume the institution in Example 1 effectively earns 42 percent on its loans, but only keeps an average of 85 percent of its portfolio in the hands of borrowers during the entire year. On average, the institution has $120,000 of its available portfolio funds of $800,000 on deposit in the local bank, earning only 12 percent.

Instead of producing a yield of 42 percent, the portfolio would only earn 37.5 percent [(0.15 x 0.12) + (0.85 x 0.42)]. Actual income would be $300,000 instead of $336,000.

As the examples above show, charging an effective interest rate equal to the needed rate of return will not produce the income an institution needs to be self-sufficient. For political reasons, the institution may need to charge a nominal interest rate commensurate with similar institutions in the area, and also charge fees. With fees, the yield of the portfolio will vary depending upon loan terms. In addition, delinquency and idle funds will make the actual rate of return of the portfolio less than the effective rate that borrowers are being charged.

Only through financial projections that consider these factors can an institution predict the level of income that a given interest rate and fee structure will produce. Furthermore, as an institution develops, the assumptions and conditions upon which the interest rate and fee structure were based will change. For example, the institution's cost structure, local nominal interest rates, and the average loan terms may change. The interest rate and fee structure must be reanalyzed and adjusted periodically.

Interest rates and self sufficiency

THE COST AND INCOME SIDES OF SELF-SUFFICIENCY

 

Income Side

Cost Side

Interest

Cost of Funds

+

Fees

+

Loan Loss Reserve

 

+

Other Operational Costs

TOTAL INCOME $

TOTAL COSTS $

% Effective Interest Rate charged to borrowers

Repayment Rate Idle Funds

% YIELD ON PORTFOLIO

and

Total Costs

Average Portfolio

COSTS AS % OF PORTFOLIO

Defining and Adjusting Interest Rates and Fees

The following is a step-by-step description of the process that microenterprise finance institutions can follow to determine an appropriate interest rate and fee structure.

Step 1

Estimate the portfolio yield needed to cover the costs of funds, loan loss reserve, and operational costs at the targeted break-even portfolio size.

Step 2

Considering the local nominal interest rates being charged by similar institutions, estimate an acceptable nominal interest rate. Estimate a fee structure that, combined with the nominal interest rate, produces an effective interest rate greater than the yield needed to cover all costs.

Step 3

Project income, taking into account delinquency, idle funds and loan terms. Adjust nominal interest rate and fees in projection until income is greater than costs at targeted break-even portfolio size.

Step 4

Evaluate the effects that the proposed interest rate and fee structure would have on some typical borrowers. An analysis of the effect that the financial costs of loans would have on the structure and level of profits of entrepreneurs in some of the most common activities to be financed will show whether or not the proposed interest rate and fee structure is feasible for the target population.

Step 6

Implement proposed interest rate and fee structure.

Step 7

Conduct periodic financial analyses and projections to determine whether interest rate and fee structure are meeting the institution's income objectives, serving the borrowers and continuing to be appropriate for the prevailing economic conditions.

Is the portfolio yielding enough for the institution to reach its targeted level of self-sufficiency given the actual costs? Continual monitoring of all of the variables used and assumptions made in the original estimates is necessary to ensure that the interest rate and fee structure remains appropriate as the institution's cost structure and the economic environment change.

Interest rates and self sufficiency

Step 8

Adjust interest rate and fee structure as conditions change. Institutions in relatively stable economies may need to make only minor adjustments every 6 or 12 months. Institutions in unstable economies with variable inflation may need to make adjustments every month or even index their interest rate so that it continually fluctuates with inflation.

SUMMARY OF FORMULAS:

1. Gross Rate of Return or Yield on Portfolio

Annual Yield = Annual gross income from interest and fees Average outstanding portfolio during year

2. Amount of Interest Payment on Simple Interest Loan

Interest Payment = Loan amount x Nominal interest rate for loan term

3. Interest Payment on Amortized Loan (per period)

Interest Payment = Loan balance x Nominal interest rate for period

4. Amount of "Flat" Interest Payment on Amortized Loan

Interest Payment = Original loan amount x Nominal interest rate for period

5. Effective Interest Rate (EIR) of Simple Interest Loans

EIR =

Amount paid in interest, fees, etc. Principal amount received by borrower

6. Approximate EIR of Amortized Loans per Payment Period

EIR =

Amount paid in interest, fees, etc. Sum of principal amounts outstanding during loan period

7. Approximate Real Rate of Interest

Real interest rate = Nominal interest rate - inflation rate

8. Actual Real Rate of Interest

Real interest rate =

(1 + nominal interest rate) -1 (1 + inflation rate)

9. Inflation's Effect on Value of Portfolio

VP f

=

VP i

 

(1+i)

where VP f is the value of the portfolio at the end of the period, VP i is the value of the

portfolio at the beginning of the period, and "i" is the inflation rate of the period.

Interest Rates and Self-Sufficiency

LESSON 4

MAKING THE CALCULATIONS

Constructing an Amortization Schedule

THE CALCULATIONS Constructing an Amortization Schedule There are several possible ways to construc t the payment

There are several possible ways to construct the payment schedule when interest is calculated on a declining balance. There are tables that can be consulted and calculators that contain the formulae required to make the calculation when provided with the basic details of loan amount, interest rate and number of instalments. The following mathematical formula can also be used to calculate the loan payments and to construct an amortization schedule.

instalment payment

=

PV x i x (1 + i) n (1 + i) n - 1

where

i

=

interest rate per payment period

n

=

number of payments

PV

=

principal amount of the loan

Once the instalment payment is calculated with the above formula, then the amount that goes toward interest and principal can be determined for each payment period. The amount that goes toward interest is the nominal interest rate times the balance at the beginning of the period. The rest of the payment (the payment minus the amount going toward interest) is payment of principal.

For example, the amortization schedule for a three-month $100 loan, with 2 percent monthly interest, would be calculated as follows:

1. Use the formula above to determine the monthly payment:

0.2 x (1 + .02) 3 (1 + .02) 3 -1

Payment = 100 x

=

100 x (.02 x 1.0612)

0.0612

=

34.68

2. Calculate the interest to be paid in the first payment:

$100.00 x 0.02 =

$2.00 interest.

3. Subtract the interest from the first payment to see how much principal is paid with the first payment:

$34.68 - $2 =

32.68

4. Subtract the first principal payment from the outstanding balance to determine the new outstanding balance:

100 – 32.68 =

67.32

Steps 2-4 can be repeated for each payment to construct the amortization schedule shown in Lesson 2.

Interest rates and self sufficiency

Calculating Effective Interest Rates

The following examples show the step-by-step process used to calculate the effective interest rate for different repayment scenarios. In all three cases, the original loan amount is $100, the loan period is three months with monthly payments, and the nominal interest rate is 2 percent per month.

The attached spreadsheet can be used to help with the calculations.

Example 1:

Interest Based on Original Loan Amount

a) Enter into the spreadsheet (Table 1a), the loan amount (PV), the loan period (n) and the nominal interest rate (i):

PV

=

100

n

=

3

i

=

2%

b) The principal paid per month, the monthly amount of interest and the total monthly payment can be seen, calculated as below:

Principal:

100/3 = 33.33 per month

 

Amount of interest:

(0.02 x 100) =

2.00 per month

Total monthly payment:

35.33

c) The effective interest rate is displayed:

2.97% per month.

Example 2:

Interest Deducted Up Front from Original Loan Amount

a)

Determine the amount to be paid in interest on an amortized basis.

Enter into the spreadsheet (Table 2) the original loan amount, the number of payment periods and the nominal monthly interest rate:

 

PV

=

100

N

=

3

i

=

2

 

The amortized monthly payment is 34.68.

If 34.68 were paid each month, then the total paid would be $104.04 (34.68 x 3), of which $100 is principal. So the balance of $4.04 is interest, which can be seen in the spreadsheet.

b)

The spreadsheet also sets out the actual monthly payment and the amount the borrower actually received:

Actual Monthly Payment is -33.33 (the actual monthly payment is only principal because the interest is being subtracted up front from the original loan amount, i.e. 100/3 = 33.33)

Amount borrower receives is 95.96 ($4.04 interest is subtracted from original loan amount)

3)

The effective interest rate is displayed:

2.08% per month

Interest rates and self sufficiency

Example 3:

Loans with Compensating Balances

The borrower receives a loan of $100, but $25 of his own money has to be kept on deposit for the life of the loan. The borrower loses the income that he could have earned on his $25 (which the lending institution can now earn). Furthermore, effectively, the borrower only gets $75 in new money to use because his own $25 is on deposit. His $25 is not lost but returned to him when he makes his final payment, effectively reducing the amount of that payment by $25.

a) Input the following assumptions into the spreadsheet (Table 3):

PV

=

100

N

=

3

i

=

2

and the amortized monthly payment shown will be 34.68 as before.

So the borrower pays 34.68 in each period but he is also incurring an additional cost in the form of lost income on his deposit. Because he is paying 2 percent per month for the loan, we can assume that his $25 deposit would be earning at least 2 percent if he didn't have to keep it on deposit. (It is earning 2 percent for the bank if they lend it to another borrower.) Thus, he is actually forfeiting 2 percent of $25 (0.50) each month in lost income. In effect his monthly payments are $35.18 (34.68 +0 .50).

When his last payment is due, he gets his $25 returned to him, meaning that he effectively pays only $10.18 (35.18 - 25) that month. So his monthly payments are 35.18, 35.18, and 10.18.

b) The spreadsheet will display the effective interest rate of this loan.

Because the payment amounts vary, the effective interest rate is calculated with the internal rate of return function in the spreadsheet. The flow of funds is:

Amount received by borrower

=

75

First payment

=

(35.18)

Second payment

=

(35.18)

Third payment

=

(10.18)

The internal rate of return (IRR) will display as 4.3%.

Thus the effective interest rate on the loan is 4.3 percent.

Interest rates and self sufficiency

Postscript

How Calculators Calculate the Effective Interest Rate

The effective rate is determined through an iterative process carried out by a calculator. Given the three variables (present value, number of payment periods, and amount of payment), the effective interest rate is adjusted through trial and error until the result of the equation below is as close as possible to the present value (amount borrower receives) of the loan.

Using a three-month, $100 loan with monthly payments of $34.68 and no additional costs, the calculator continually adjusts the value of / (interest) until the sum of the Formula column equals the present value of the loan ($100 in this case).

Payment Period

Payment

Formula

   

34.68

1

34.68

(1 + i) 1

   

34.68

2

34.68

(1 + i) 2

   

34.68

3

34.67

(1 + i) 3

Total present value (amount borrower receives):

100.00

In this case, the value of i which correctly completes the equation is 0.02, meaning the loan has an effective monthly interest rate of 2 percent.

Interest Rates and Self-Sufficiency

QUESTIONS AND EXERCISES

INTEREST RATE PROBLEMS

QUESTIONS AND EXERCISES INTEREST RATE PROBLEMS Note: Some of these problems require the use of the

Note: Some of these problems require the use of the attached spreadsheet.

A. Nominal, Real and Effective Rates of Interest

1. What is a negative real interest rate? How is it affected by an increase in inflation?

2. What are nominal interest rates and how are they affected by:

a. A dramatic increase in inflation?

b. An increase in the commission on a loan?

3. What are effective interest rates and how are they affected by:

a. A dramatic increase in inflation?

b. An increase in the commission on a loan?

4. Besides financial costs, what other kinds of costs do borrowers pay for a loan? Give examples.

Interest rates and self sufficiency

5. What differentiates transaction costs from financial costs?

6. José Martínez is a carpenter who needs $500 to purchase wood. He would be able to repay the loan in equal instalments over a six-month period. He has two alternatives for the loan: the Loans for Entrepreneurial Development (LED) program or Margarita, the money lender. Both sources offer him $500 for six months with monthly payments but differ in terms of their specific charges which are specified below:

Loans for Entrepreneurial Development

3 % monthly interest calculated on a declining balance. 3% loan processing fee (added to the loan amount and paid in full upon loan disbursal). $10 flat fee for fiscal stamps (added to the loan amount and paid in full upon loan disbursal).

Note: The loan amount would be for [500 + 10 + (0.03 x 500)], but Jose would only receive 500 as the rest would cover the fee and commission.

Margarita the Moneylender

5% monthly interest calculated on original loan amount (flat), payable monthly.

a. Given the specific conditions of each of these sources of credit (detailed above), use the spreadsheet to work out which has the lowest financial cost, i.e. effective interest rate.

b. What other factors might José feel are important for deciding between the different alternatives?

Interest rates and self sufficiency

7. The Microenterprise Credit Association (MCA) provides loans to micro entrepreneurs in a country where annual inflation is 22%, with the following conditions:

2 % monthly interest on declining balance

6 – 12 month loan terms

monthly payments

3 % commission payable upon loan disbursal

$2 flat fee for fiscal stamps payable upon loan disbursal

(Note: as in question 6, the fee and commission are added on to the amount to be received by the borrower, but then kept by the lending institution.)

a. What is the annual nominal interest rate?

b. What is the real annual nominal interest rate?

c. What is the monthly effective interest rate?

8. Marie makes clay pots and receives a $350 loan for six months from MCA (see Q.7 for terms of loans from MCA).

a. How much does she pay in commissions and fees?

b. How much does she pay in interest? (Use the spreadsheet for this and questions c and d.)

c. What is the monthly effective interest rate on her loan?

d. If MCA calculated interest based on the original loan amount rather than the declining balance, how do the above values change?

e. Why is the effective interest rate higher when interest is calculated based on the original loan amount (flat method), than using the declining balance method?

Interest rates and self sufficiency

9.

Assume that Marie receives the same $350 loan (as in question 8), but for 18 months instead of 6 months.

a. Use the spreadsheet to work out how much would she pay in interest over the 18 month period, remembering that the interest is based on the declining balance. What is the effective monthly interest rate?

b. If interest were based on the original loan amount, how much would she pay in interest over the 18 month period? What is the effective monthly interest rate?

10.

What happens to the costs of the loans (both on a declining balance and on the original loan amount) and to the effective interest rates when the loan term is increased? Can you explain these changes?

B.

Setting Interest Rates

1.

What three types of costs should a lending institution try to cover with its income from interest and fees? Explain each type and give examples of the costs within each category.

Interest rates and self sufficiency

2. How can a lending institution maintain the value of its portfolio in a country where inflation is 22 % per year?

3. How does inflation affect an institution's portfolio? What is the effect on the portion of the portfolio that is borrowed from a bank? What is the effect on the portion of the portfolio that is the institution's own resources?

4. Which package of loans below (A or B) generates more income for a lending institution in one 12 month period, and why? For both A and B assume that funds are lent out again as soon as they have been repaid, thereby never remaining idle, and that on-time repayment is 100%.

 

A

B

Outstanding Portfolio

$10,000

$10,000

Loan Terms

3 months

12 months

Average Loan Size

$100

$1000

Fees or commissions

None

None

Monthly interest rate

2 % (declining balance)

2 % (declining balance)

Interest rates and self sufficiency

5. The Microenterprise Credit Corporation (MCC) is opening a new credit program in January 2002 and is trying to decide how much in interest and fees to charge the borrowers. MCC's goal is to cover all costs, and maintain the value of the portfolio, by the end of the third year (2004). MCC predicts that its average loan size will be $500 and the average loan term six months. MCC's financial projections show the following situation for 2004:

Amount of portfolio belonging to MCC (donated or retained earnings):

Amount of portfolio borrowed:

Asian Development Bank (4% interest charge per

National Bank (18% interest charge per year)

Private Bank (22 % interest charge per year)

year)

275,000

500,000

200,000

100,000

TOTAL PORTFOLIO

1,075,000

ESTIMATED LOAN LOSS (2004)

25,000

ESTIMATED OPERATIONAL COSTS (2004)

161,250

ESTIMATED INFLATION RATE (2004)

18 %

a. What yield does MCC need to earn on its portfolio if it is to break even in 2004?

Interest rates and self sufficiency

b. Assume that all borrowers pay on time, and that the entire portfolio is always lent out.

How could the program charge a nominal rate equal to the nominal rate of commercial

banks (22%) and still break even?

c. Instead of charging any fees, MCC in 2004 charges 30% interest on a declining balance on all loans. MCC shows the following results for the year:

No interest is earned on the 2.3 % of the portfolio which is to be written off at the end of the year;

12% of the portfolio does not generate any interest income during 2004 because of delinquency.

Costs are the same as projected.

All $1,075,000 is lent out to borrowers for the whole year.

How much is MCC's deficit in 2004?

d. Assume that all of the conditions set out in c above are true, except the last one. Instead,

MCC has an average of 10% of its portfolio on short-term deposit earning 20% during 2004,

while the rest is always m the hands of borrowers. How much is their deficit under these

conditions?

e. If MCC could have predicted the results described above, what could they have done to diminish or eliminate their deficit in 2004?

Interest Rates and Self-Sufficiency

SOLUTIONS

INTEREST RATE PROBLEMS

A. Nominal, Effective and Real Interest Rates

RATE PROBLEMS A. Nominal, Effective and Real Interest Rates 1. Approximate real interest rates are calculated

1. Approximate real interest rates are calculated by subtracting the inflation rate from the interest rate. The precise formula is:

real interest rate = (1 + nominal interest rate) - 1 (1 + inflation rate)

If a real interest rate is negative, it means that the interest charge is less than the inflation rate. Even if all of the interest paid is used to capitalize the portfolio, the portfolio will be worth less each year. As inflation increases, the real rate of interest becomes more negative.

2. Nominal interest rates are the rate of interest that the lender states the borrower will pay. They are used to calculate the amount of interest to be paid in each payment period: the nominal interest rate times the outstanding (declining) balance of the loan.

a. A dramatic increase in inflation does not change the nominal interest rate of a loan. Increasing inflation will decrease the real nominal interest rate.

b. An increase in the commission on a loan will not change the nominal interest rate of the loan.

3. Effective interest rates most accurately reflect the actual costs of a loan. They combine the effects of the calculation method and the costs of interest, commissions and fees over the period of the loan, and interpret them into one rate.

a. Effective rates do not change with inflation. The real effective rate of interest will vary with inflation.

b. An increased commission will result in a higher effective rate of interest on a loan.

4. Borrowers have to pay transaction costs for loans. They include transportation to the lending institution, fees for the preparation of documents in order to qualify for the loan, and even the borrower's own time that would otherwise be used generating income. Transaction costs also include costs incurred because of inefficiencies in the lender's delivery system, such as extra trips to the lender because the lender misplaced a document, or a missed opportunity to buy raw materials at a special low price because the loan is delayed.

5. Transaction costs are paid by the borrower, but not to the lender. Financial costs are paid directly to the lender. To the greatest extent possible, lenders should try to minimize the transaction portion of the total borrowing costs that their borrowers must pay.

6. José’s loan - financial costs of each alternative:

Loans for Entrepreneurial Development Program

You should have entered these values in the spreadsheet section 1b:

Original loan amount: $500 Fees and commission: $10 + ($500 x .03) = $25 Number of payments: 6 Nominal monthly interest: 3%

Monthly payment is:

Effective interest rate is: 4.49% per month

$96.91

Interest rates and self sufficiency

Margarita the Moneylender

Solutions to problems

You should have entered these values in the spreadsheet section 1a:

Original loan amount: $500 Number of payments: 6 Nominal monthly interest: 5%

Monthly payment is:

Effective interest rate is: 8.05% per month

$108.33

a. So the loan from the Loans for Entrepreneurial Development Program has an effective interest rate of 4.49% per month, which is less than the 8.05% charged by Margarita.

b. Even though the financial costs of the moneylender are higher than those from LED, José should also consider the transaction costs. If the LED is far from his house and he would have to make numerous trips, then the transaction costs of the LED loan could be higher than Margarita's loan. Or, if José has a special opportunity to buy raw materials at a very low price, and Margarita could give him his loan in time to buy the materials at that price but LED could not, then his total borrowing costs might be lower with Margarita than with the LED.

7. a. The annual nominal interest rate is: (2% x 12) = 24%

b. The real annual nominal interest rate is: (24% - 22%) = 2%

c. The monthly effective interest rate cannot be determined with the information given. In order to figure out the effective interest rate, one has to know the loan size (or the payments per period) and the number of number of payment periods. With an average loan size and loan term, an average effective interest rate could be calculated.

8. Marie's 6-month loan of $350

a. Amount paid in commissions and fees ($350 x 0.03) + $2 =

$12.50

To calculate interest, the following figures should have been entered in spreadsheet section 1b:

Original loan amount: $350 Fees and commission: $12.50 Number of payments: 6 Nominal monthly interest: 2% This would indicate that:

b. The amount paid in interest is:

c. The effective interest rate is: 3.05% per month

$25.79

d. The amount paid in commission and fees stays the same, i.e. $12.50

These values should have been entered in spreadsheet section 1a:

Original loan amount: $350 Fees and commission: $12.50 Number of payments: 6 Nominal monthly interest: 2%

This would indicate that the amount paid in interest is: $43.50 and the effective interest rate is: 4.41% per month.

e. The rate is higher when interest is calculated on the original loan amount because the borrower is paying interest on $362.50 for the full six months, even though she is making monthly payments of principal and only owes the full $362.50 during the first month. When interest is calculated on the declining or outstanding balance of the loan, interest is paid only on the amount that the borrower owes during each payment period.

Interest rates and self sufficiency

Solutions to problems

9.

Marie’s 18 month loan of $350

a. You should have entered these values in the spreadsheet section 1b:

Original loan amount: $350 Fees and commission: $12.50 Number of payments: 18 Nominal monthly interest: 2%

This would indicate that the amount paid in interest is: $72.73 and the effective interest rate is: 2.40% per month.

b. You should have entered these values in the spreadsheet section 1a:

Original loan amount: $350 Fees and commission: $12.50 Number of payments: 18 Nominal monthly interest: 2%

This would indicate that the amount paid in interest is: $130.50 and the effective interest rate is: 3.88% per month.

10.

When interest is calculated on the declining balance and the loan includes commissions or fees, then the effective interest rate decreases as the loan term increases. (Note: if there were no commissions or fees, the monthly effective rate would remain the same). The rate decreases because the impact of the commissions and fees is spread over more payment periods and the nominal rate remains the same for each payment period. Because the borrower is using the money over a longer period of time, however, the total amount paid in interest is greater over the 18 months than the 6 months.

When interest is calculated on the original loan amount both the effective interest rate and the total amount paid in interest increase dramatically as the loan term increases. The borrower is paying interest over a longer period of time for an amount (the original loan amount) increasingly greater than the amount the borrower is actually using (the outstanding balance of the loan).

B.

Setting Interest Rates

1.

A self-sufficient lending institution covers three types of costs with the income it earns from interest, commissions, and fees on loans. The cost of funds is what the institution must pay for the resources that it uses to lend. These costs include interest and fees on loans, costs related to any grants or loans, and the cost of inflation on the institution's own resources so that they do not lose value. The institution must also maintain a loan loss reserve. The reserve is capitalized from the institution's income and is a cost. Lastly, the institution needs to pay its other operational costs, which include salaries, rent, and supplies.

2.

For the portion of the portfolio that is the institution's own funds, the institution should assign a cost of funds of 22%. That cost is then included when the interest rates to the borrowers are determined. The income earned by the 22 % charged on that portion of the portfolio should then be reinvested in the portfolio, enabling the institution to maintain the value of its own funds in the portfolio.

3.

Inflation eats away at the value of the institution's portfolio. If some of the portfolio is borrowed from a bank and the inflation rate increases beyond the interest rate that the institution must pay the bank, then the institution will actually have to repay the bank less money (in value) than it borrowed. At the same time, however, the value of the amount available to lend to borrowers will be decreasing. The institution’s own resources will lose value as inflation increases.

4.

Both generate the same amount of income. Assuming the money is never idle (it is lent out again as soon as it has been repaid), both portfolios earn 2% of $10,000 ($200) each month, even though portfolio "A" is turning over faster than "B". If the same fee were charged for loan processing or disbursal in both cases, then portfolio "A" would generate more income than "B" because it is making more loans and lending out more money than B.

Interest rates and self sufficiency

5. Yield needed by MCC

Step 1:

Calculate the cost of funds as a percentage of the portfolio:

Solutions to problems

There are four sources of funds for the portfolio (three banks and the institution's own resources), each with a different cost. The proportion of the portfolio and cost, from each source are:

Source

Proportion

Cost

Own funds:

275,000/1,075,000 = 0.26

0.18 (inflation)

Asian Dev. Bank:

500,000/1,075,000 = 0.46

0.04

National Bank:

200,000/1,075,000 = 0.19

0.18

Private Bank:

100,000/1,075,000 = 0.09

0.22

The cost of funds for the entire portfolio, including the effects of inflation on the institution's

own funds, is (.26 x .18) + (.46 x .04) + (.19 x .18) + (.09 x .22) =

0.1192, i.e. 12%.

Step 2:

Calculate the loan loss reserve as percentage of portfolio.

The projected loan loss is $25,000 with a portfolio of $1,075,000.

Loan loss reserve: 25,000 / 1,075,000

=

0.023 or 2.3%

Step 3:

Calculate the operational costs as percentage of portfolio.

The projected operational costs with a portfolio of $1,075,000 are $161,250.

Operational costs as % of portfolio:

161,250 / 1,075,000

=

0.15 or 15%

Step 4:

Add these three percentages:

Yield needed: (12 + 2.3 + 15)

=

29.3 %

a. So MCC would need to earn 29.3 % on its portfolio of $1,075,000 to cover all of its costs.

b. They could set their nominal interest rate at 22% and then charge fees that would earn them 7% or 8% per year. MCC would have to earn $86,000 (.08 x 1,075,000) per year in fees. With an average loan term of 6 months, the entire portfolio will turn over every 6 months, or twice during the year. A total of $2,150,000 will be lent out during 2004. If MCC charges a 4% fee on each loan as it is disbursed, they will earn $86,000 in fees. MCC would charge 22% interest plus a 4% fee for their loans.

c. With 12% of the portfolio not generating interest income and 2.3% not being paid at all and being written off, then only 85.7% of the portfolio provides interest income during 2004. The amount of income that will actually come in during the year would be: (1,075,000 x .857 x .30) = $276,383.

Total costs for the year are projected as follows:

Cost of funds

$129,000

(.12 x 1,075,000)

Loan loss reserve

$ 25,000

Operational costs

$161,250

$315,250

Because of default and delinquency, MCC will earn $276,383 during 2004 but have costs of $315,250 giving a deficit of $38,867.

Interest rates and self sufficiency

Solutions to problems

d. In this case, 10% of the portfolio ($107,500) earns 20%, 14.3% of the portfolio ($153,725) earns zero because of delinquency and 75.7% ($813,775) earns the full 30%.

Total income is:

(107,500 x .20) + (153,725 x 0) + (813,775 x .30) =

$265,633

Total costs are the same as in question c. $315,250, so MCC's deficit would be $49,617.

e. To reduce the deficit, MCC could have implemented any combination of the following strategies:

lowered its costs

prevented such high levels of delinquency and default

increased its interest rate

added a fee on all loans

charged a penalty fee for late payments

In other words, they needed to find a way to increase their income or decrease their costs.