Microfinance Interest Rates as a Function of Transaction Costs

It is often observed that the interest rates charged to borrowers of micro-loans are quite high. According to the United States Federal Reserve Board, the average interest rate charged by commercial banks for a 24-month personal credit loan was 12.22% in the third quarter of 2005. The average annual percentage rate charged on credit card debt was only slightly higher at 12.48% for Q3 05; yet the APR charged for a typical loan by microfinance institutions (MFIs) in India ranged from 20% to 40% (p.4) in 2003. In lesser developed nations such as Indonesia or the Philippines rates reached up to 80% (p.4). These rates are quickly and errantly decried as exorbitant and usurious, when, in fact, they are the product of some of the most fundamental principles of economics and are advantageous not only for the lender, but the borrower as well.
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