The Scrooge Takes a Look at Investing in Micro-LoansDecember 21st, 2012 by Marc Prosser
A micro-loan is a small loan, typically less than $1,000. These loans are generally made to very poor people all over the world, for the purpose of helping them start a business. For example, one could provide a micro-loan to help a woman in a rural area of India buy a cell-phone. In turn, she could charge her fellow villagers to make calls and earn money to pay back the loan. The beneficiary of the loan would not only be the woman, but the entire community which would now be able to more easily communicate with the outside world.
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Micro-loans are different than typical loans in many ways. They are generally administered by non-profits rather than banks. They are for amounts much smaller than a typical bank loan and made to people that would not qualify for a bank loans. The goal of the lender is not to earn a profit, but to benefit the community. However, they are still loans. Those involved in micro-loans have emphasized the importance of the loans being paid back. In other words, micro-loans are not grants, but debts that are expected to be repaid over time.
The Good News – 99% of Kiva Loans Are Paid Back.
The most well known charitable organization in the United States that facilitates micro-loans is Kiva.org. Almost 1 million lenders (857K to be precise) have made almost $400 million dollars worth of micro-loans through Kiva. Neither the lenders, nor Kiva.org, earn interest on these loans. In other words, lenders are giving up / “donating” the potential interest on these loans. Also, lenders potentially face losses if these loans are not repaid. In theory, the the default rate on these loans should be very high. The borrowers have minimal assets, and no buffer against hard times. However, the default rate is only 1%. An amazing 99% of loans get paid back. If you add up the default rate and the forgone interest that could have been earned, the “cost” of making a micro-loans is around 4%, or about $40 on $1,000 loan.
The appeal of micro-loans is that while making a relatively small “donation”, you can can make a large and meaningful difference to a person and community. Do micro-loans work?:
Research Shows That Micro-Loans Don’t Reduce Poverty
What is the impact of micro-loans on a community? Does providing lots of small micro-loans help raise a community out of poverty? One researcher, David Roodman, recently wrote a book on this topic, Due Dilligence: An Important Inquiry Into Micro-Finance. His conclusion after carefully reviewing the 20 or so plus studies on the impact of microfinance was that most studies that found a positive impact were severely flawed. His conclusion:
zero is the best estimate given limited rigorous evidence of the impact of microcredit on the income and spending levels of clients.
Micro-loans don’t reduce poverty?
I was sure this claim would be immediately and severely rebutted by micor-lending organizations like Kiva and the Grameen Bank which started providing micro-loans in the 80s. Using Google, I was not able to find very much in way of rebuttal, except by a professor or two which took issue with his methodology.
Not finding an online rebuttal, I contacted Kiva.org by phone. I asked them for a response. In fact, I pleaded with them to give me hard evidence which would allow me to refute Roodman’s claim. After waiting for two weeks without a response, I am publishing this story.
Roodman’s book leads to a bigger question.
Why don’t micro-loans enable communities to climb out of poverty?
Here are some ideas that I have:
1) The enterprises that micro-loans tend to finance don’t scale. In the beginning, I mentioned the woman buying the cell phone. Will her enterprise lead to hiring others or just impact her particular situation? Put another way, are micro-loans by their very nature too small to make a difference (hire people, buy machinery, etc.)?
2) Is the high repayment rate on micro-loans a problem? To get a 99% repayment rate, there is tremendous pressure put on borrowers by the community around them. When a borrower doesn’t repay, often their community (also in poverty) will repay the loan. Anecdotally, there are stories that the community will take the borrower’s roof or animals afterwards. As there are big risks to the borrower for non-payment, do borrowers make only super conservative economic decisions, which prevent the transfer of economic prosperity.