Tuesday, April 24, 2007

Paying interest to Kiva lenders

Disclaimer / Challenge: please note that the blog post you're reading is based on my personal insights and logic I think is true. As I have no economics or financial background at all, I would be thrilled to be proved wrong. Please let me know if you don't agree with my logic or assumptions, or if you think there is more to the story than the side I present here. This is an important topic that goes to the core of "why Kiva". Please post comments, or email me if you want to keep it private.

There is a long, ongoing discussion at Kivafriends about Kiva paying (or not paying) interest to lenders. I've given my opinion on this topic already in the past (specifically in the Kivafriends thread that I linked to above), but here's some more in-depth thought:

I think that parts of Premal's interview with the PBS series Frontline/World give some specific clues about why Kiva is considering giving interest to lenders.

Let me start to repeat myself: personally, I am not at all interested in getting interest for my current loans. But, truth being truth: this attitude does tremendously restrict the amount of money I am willing to invest in Kiva loans. In this interview, Premal specifically said:
And in truth, there's a lot more money in the investment capital pool than in the donation capital pool.
This kind-a says it all. Currently, there is no need for Kiva to give interest to lenders. Giving no interest keeps the cost of money to the MFI low. If Kiva would give interest to compete with money market accounts, it'd be somewhere around 5-7%: 3-5% of actual interest, and another 2-3% to cover the risk of loan default. If you'd put in a large sum of money spread out over many loans, the lender would need 5-7% of interest per loan to get an actual return of 3-5%, which is in line with current US money market accounts. The argument here would be that it would be a pure financial return and no emotional return.

I don't think that charging that much interest would be feasible. It would immediately kill Kiva's value proposition to the MFIs, because now the cost of money to the MFI quickly approaches the commercial loans that are already available to them.

In all reality, the current "no interest"financial return should long-term be somewhere around -2 to -3% (which is the expectable long-term default rate), maybe even a little bit lower-- what happens if the lender or the MFI cannot pay back because of exchange rate problems? The MFI is specifically supposed to cover this, but this could easily put loans in default in countries where for some reason the currency exchange rate goes haywire. The probability of loans default because of change in macro-economic circumstances would need to be added to the expected default rate.

So Kiva is looking for the "golden path" between financial and emotional return. Giving a few percents of "positive" interest won't create a real financial return for investors that is comparible with what they would get in the market, where a diversified short-term investment yields around 4% ($10K MMA account or CD, source: bankrate.com on April 24, 2007). They will -best case- break even on their loan if Kiva gives 2-3% interest, as is my understanding of the current state of things.

In summary:
  • Kiva should only give interest if the market-need for money (i.e., the amount of micro-loans to be raised) is so large that loans can't be fulfilled with the current set of charitable lenders
  • In order to compete with commercial loans, Kiva would need to give around 7% interest to lenders: ~4% real interest, and ~3% to cover for losses because of expected default. This would put the loans in range of similar investments.
  • Charging 7% interest kills Kiva's value proposition to the MFIs.
  • Kiva could consider giving a little bit of interest (say, 2%) to lenders.
Would the latter work?
Unfortunately, in my opinion, I don't think so:
  • Giving 2% interest to lenders won't attract the huge amount of commercial investments that would be needed to exponentially grow Kiva.
  • As for the marketing (PR) effect of this, I think it will be PR-neutral: it will attract some new lenders, but it will equally put off lenders that invest in Kiva loans because of charitable reasons: they will feel a reduction in emotional return, which is their main reason of investing.
  • In reality, all it will do is make the loans a few percent more expensive for the MFIs, and thereby reducing the social impact that this has on the poor, Third World micro-entrepreneur. And this social impact is what makes Kiva so great compared to other lenders out there.
  • In conclusion, the choice would be to make a small impact on a very large set of poor, Third World micro-entrepreneurs or to make a large impact on a few. My personal choice is the latter.
Which brings me back to the (now updated) original position: I don't want interest for my Kiva loans. But if I'd want interest, it would be too high for Kiva or the Third World borrower to afford.


dgandhi said...

I added to the discussion on my blog(linked on my name) as well, though I disagree on the economic incentives involved.

Andrew said...

Kiva loans aren't donations. Currently, they are loans that the lender gets paid back in full.

The loanees are the ones that have to pay interest to the respective Kiva MFI partner that dispurses the loan. So, technically they're interest-free only for Kiva loaners.

I'm guessing that Kiva's MFI partners could all be a bit more efficient with their dispursal and collection systems. I think that requiring Kiva's partners (since the entrepreneurs already pay interest) to pay interest will encourage them to become more efficient. And, this will highly benefit micro-entrepreneurs in the long run.

Anonymous said...

the loan i looked at for a vietnamese group had a default payback of %82. That means I would need to make something like %25 to approach money market rates.

Also, the "partners" are charging the borrowers something like %22. I can't say i'm thrilled about losing 20 cents on the dollar so I can fund a vietnamese company that lends out money at %22.

So lets see:
I give $100 to BinhMinh which loans it out at 22% interest.

BinhMinh pockets the 22% on every payment made and give me back just the principal.

The loan goes in default after I've been paid $82

So, I lose $18, BinhMinh makes something like $17.

Why don't I just send $18 to the borrower directly and call it a day?

Anonymous said...

I would be perfectly fine with 1% interest, that way you really are not hurting the person you are loaning to and the money you can loan on the site would increase with each loan thus helping more people down the line. Kind of like paying it forward. Maybe the interest on the loan could not be directly paid back to the loaner, but be kept on the website ear marked for the user.

Anonymous said...

You're also neglecting a few things. First, the time value of money. Your money is sitting there, loaned out, and not making you interest. That money could be in the bank. It could be earning you 3%. So by having it in Kiva, you're losing that potential zero-risk 3% return. That's a loss.

Also, I'm not sure how Kiva handles currency risk, but if the value of the dollar vs. the local currency skyrockets, that loan will still end up costing someone a lot of money. I'm not sure who gets stuck holding the bag though.

Anonymous said...

I realize this post is old but it's the top of the search for kiva interest so I wanted to add for other searchers - Kiva's partners are charging anywhere from 20-80% interest to those "poor people" without access to credit. Available on their own site. So in reality, your actual payback rate would be even lower and longer considering that only say at worst case scenario, each increment paid is only 20% spread out among the "lenders".

This means if there are 10 lenders at their $25 each, for everyone to be 100% satisfied, the borrower has to pony up somewhere around 4 times the cost of the loan to begin with.

From there, lets say on that $250, the payments are $50 per month. Only $10 is disbursed the first month to ALL the lenders. The interest is racking up and the next month, after that $50 payment, the borrower still owes over $235 (after fees). So you get a buck, Kiva partner gets $40. At that rate, it would take almost 2 years to get your initial $25 back.

Again, this is the worst case scenario, minimum paying, etc. But at the end - you've lost maybe $5 in investment interest (if you get paid 100%) and Kiva partners have made 100's of dollars for a $250 loan. Kiva's partners have essentially eliminated any financial burden in the first payment, putting it all on lenders.

If you get paid back only 80%. Not only have you lost the $5 from investing, you've lost another $5 over 2 years.

Ambassador Kasunic said...

Personally, it would be great to earn some money on the loans I have out via kiva. It would not be an economic decision at all, but would make me feel like I am participating in a fair market exchange, rather than just giving the money away. That has a greater emotional return for me. I've already had someone default, so oh well, but would be cool to see it grow in value. Definitely would encourage me to lend more. May be some places where it could be a very good economic return. Heck, with savings accounts earning a half a percent today, 2-3% is 6x the market rate (though there is more risk in the microloans)