What kind of charity charges an interest rate?

By Duncan Parker

CEO Fredericks Foundation

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Background

Microfinance is a general term to describe financial services to low-income individuals or to those who do not have access to typical banking services. In Fredericks Foundation case, we lend to those typically excluded from mainstream lending, usually because of credit history issues.
Fredericks (and therefore the microfinance ideology) believe in the idea that low-income individuals are capable of lifting themselves out of poverty if given access to financial services. While some studies indicate that microfinance can play a role in the battle against poverty, it is also recognised that is not always the appropriate method, and that it should never be seen as the only tool for ending financial difficulty.

Go Fishing!

You will be familiar with the proverb ‘ give a man to fish, he’ll eat for a day, teach a man to fish he’ll eat for a lifetime. Well the ideology of micro finance as a poverty alleviation tool takes this a step further and enables the man (and woman) to own their own fishing rod and tackle by lending them money. This has two main benefits… firstly, the money that someone donates to us helps people over and over again (and one day we can stop fundraising) and secondly, it gives the beneficiary (we call them clients) self esteem as they have not received a hand out, but rather a hand up.
Charging an interest rate enables us to protect our capital and generate revenue to cover our overheads. If we are not sustainable we will not survive. If we do not survive, our clients will be at the mercy or more predatory lenders.

Fredericks accepts a higher than normal level of risk to help those most in need and our interest rate in some way helps to protect against that risk of loss and so protects the donation given to us.
Fredericks is a charity providing loans to those who are unable to obtain credit to start or support their businesses. Initially our interest rate was 4 %. However, after 9 years of data we found on review that this was not sustainable and had some difficult choices- either we stopped lending or we increased our interest rate. We did the latter. 

We increased our rate to 19% Apr. 
We found: 
 With increased support defaults went DOWN. Thus interest rate is NOT material in the businesses success. Far more important is the business plan and support. Our default rate is half that of commercial operators in this sector before they abandoned it all together

We work on a reducing balance and believe our rate to be affordable. For instance, our average loan is £5000 over 3 years. The cost total is £6664. Moreover Clients can pay back early WITHOUT PENALTY.

If our clients can get a loan less expensively we encourage them to do so. We are really lender of last resort. 

Fredericks lends responsibly. If we think they cannot afford repayments, we will note make a loan. 

We are willing to make very small business loans.  It is as costly to do this in terms of staff time as it is to make a larger loan (in fact, arguably more so because people need support to develop the loan application), but obviously we earn far less on these small loans.  

We also have to cover capital losses, which will be higher at this end of the market.  However, it still represents far greater value than a grant, since we get ~70% of the principal back, which can be redeployed.

The mentoring offer is embedded in the loan, so clients are deriving that value without having to pay an additional fee for it.

 Finally compare our APR with market leaders : ours is 19% theirs is 1500% or even standard institutions such as the banks, FOR THIS MARKET SECTOR FREDERICKS IS VERY COMPETITIVE.

 "Fredericks provides a vital service offering not just money but bespoke support appropriate for the client I cannot speak highly enough of them"
Little p nursery. 

Blimey – this is interesting…I’ll read a little bit more….

Microfinance is a general term to describe financial services to low-income individuals or to those who do not have access to typical banking services. In Fredericks Foundation case, we lend to those typically excluded from mainstream lending, usually because of credit history issues.
Fredericks (and therefore the microfinance ideology) believe in the idea that low-income individuals are capable of lifting themselves out of poverty if given access to financial services. While some studies indicate that microfinance can play a role in the battle against poverty, it is also recognised that is not always the appropriate method, and that it should never be seen as the only tool for ending financial difficulty.

Why do we charge interest? Don’t charities usually give money away?

Microfinance providers believe that the best way to combat poverty (in many cases – not all) is to find a sustainable solution – one that doesn’t need constant new funds – in our case as a charity, continued fundraising and donations. This makes us very different from many other types of charity who need to fundraise on a continual basis to deliver their services (i.e. animal welfare charities, health care charities, elderly care charities etc.).

Microfinance is different – the money we receive from donors (or investors) has the potential to never disappear an if managed well, actually grown. We lend £1 out, and we expect to get that £1 back. In a perfect world where there were no costs to the transaction (i.e. if all our infrastructure was free, all our staff were volunteers and most importantly, we always recovered the £1 lent out) we wouldn’t need to charge interest – unfortunately that isn’t the case. So let’s look at those costs in more detail.

Costs that Fredericks have to pay

There are three kinds of costs that Fredericks has to cover when it makes microloans. The first two, the cost of the money that it lends and the cost of loan defaults, are proportional to the amount lent. For instance, if the cost paid by us for the money we lend is 10%, and it experiences defaults of 4% of the amount lent, then these two costs will total £14 for a loan of £100, and £70 for a loan of £500. An interest rate of 14% of the loan amount thus covers both these costs for either loan.
The third type of cost, transaction costs, is not proportional to the amount lent. The transaction cost of the £500 loan is not much different from the transaction cost of the £100 loan. Both loans require roughly the same amount of staff time for meeting with the borrower to appraise the loan, processing the loan disbursement and repayments, and follow-up monitoring. 

At first glance, interest rates can look high to many people, especially when the clients are poor. But in fact, this interest rate simply reflects the basic reality that when loan sizes get very small, transaction costs loom larger because these costs can't be cut below certain minimums. 

Profitability and sustainability of MFIs

In our sector, excessive concern for profit in microfinance, and the demands of some funders, is leading other MFIs away from poor clients to serve better-off clients who want larger loans. It is true that programs serving very poor clients are somewhat less profitable than those reaching better-off clients, but this is where Fredericks Foundation feel called to serve. 
 
There are cases where microfinance cannot be made profitable, for example, where potential clients are extremely poor and risk-averse or live in remote areas with very low population density. In such settings, microfinance may require continuing subsidies. Whether microfinance is the best use of these subsidies will depend on evidence about its impact on the lives of these clients.