It is often observed that the interest rates charged to borrowers of micro-loans are quite high. In lesser developed nations such as Uganda, rates have reached up to 117 percent as latest as the year 2005. These rates are quickly and errantly decried as exorbitant and usurious, when, in fact, they are a product of some of the most fundamental principles of economics. They are advantageous not only for the lender, but the borrower as well.

Interest rates charged for lending depend on a number of factors. Of these, transaction costs and risk figure prominently. Three types of costs are associated with the lending process: the cost of funds for on-lending, the cost of risk (loan loss), and administrative costs (identifying and screening clients, processing loan applications, disbursing payments, collecting repayments, and following up on non-repayment). Microlenders are thus subject to significantly higher transaction costs than banks in the developed world.

With regard to loan administration, Microcredit is an industry that is heavily dependent on personal contact. This is time-consuming, resource intensive and allows each loan officer to reach a limited audience of potential borrowers. The administrative process is not only less efficient for each loan, but a micro-lender lends small sums of money to many borrowers, thereby multiplying the total administrative costs by a large number of borrowers. Leading to a higher transaction cost per loan.

Comparing the costs of a Big Lender (BL) and a Micro lender (ML), who lend Ksh.1 million each; a BL makes a single loan, while a ML makes a hundred loans of Ksh.10,000 each. The costs of capital and loan loss risk vary proportionally with loan size. Both lenders need to raise Ksh.1 million to fund their loans and will have to pay the same market rate—say, 10 percent—for the money. If both lenders have a history of losing 1 percent of their loans to default each year, they will need a loan loss provision of that amount. They can cover the cost of their capital and risk by charging 11 percent on the loans they make to their customers.

Administrative costs are not proportional to loan size. Making a single loan of Ksh.1 million might cost a BL Ksh.30,000 (3 percent of the loan amount) in expenses, this could be in terms of staff appraising, disbursing, monitoring, and collecting the loan. BL’s can cover all his costs by charging the borrower an interest rate of 14 percent.

ML’s administrative costs for each loan will be much higher than 3 percent of the loan amount. Instead of Ksh.300 per borrower, ML is more likely to spend Ksh.1,000 or more per borrower. Whereas a BL has to deal with only a single borrower, a ML deals with a hundred borrowers who typically do not have collateral, financial statements or records in the database of a credit reporting bureau. Collecting from such clients requires time-consuming personal interaction.

Assuming a BL’s loan is repaid quarterly, it has to process four payment transactions per year. ML’s borrowers probably make repayments monthly or even more frequently, generating at least 12,000 transactions per year. While BL’s administrative cost is Ksh.30,000 per year, that of a ML is at least Ksh.100,000. Covering this cost requires a 10 percent charge on the loaned amounts, resulting in an interest rate of at least 23 percent. Note that administrative costs may be much higher in young Microfinance Institutions (MFIs) that are too small to take advantage of economies of scale.

It is apparent that a considerable portion of the higher interest rate charged to borrowers by MLs is derived from increased costs associated with the transaction. It is a simple fact of business that costs must be covered in order to continue operation. Further premiums must still be added to the interest rate to account for the many and varied risks assumed by a micro-lender and keep him in business.

Additionally, default risk is also a critical part of any lending decision and micro-lending is no exception. As much as micro-lending is trumpeted as having high repayment rates, information to support this is limited at best. Compounding default risk, the lender often has limited, if any, courses of action to mitigate damages.

Most borrowers from MFIs' lack assets to back-up their loans. Seemingly, developing countries lack civil infrastructure, such as, adequate court systems to collect bad debt. Without a safety net for defaulted loans, micro credit portfolios can quickly go bad if borrowers perceive that there are no consequences for loan default.

The higher interest rates charged for micro-loans are, in effect, insurance against default, a premium for the added risk. Despite these high interest rates, micro-loans still provide positive marginal benefits for borrowers. Moreover, the potential to increase these benefits exists as the infrastructure of the industry grows, lowering costs. The high rates charged by microlenders are still considerably lower than those charged by informal sources.