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How do MFI Clients Understand their Loan Contracts?
Minakshi Ramji and Michael Chasnow, project managed by Anvesha Khandelwal and Akhand Tiwari


In recent years, microfinance policy and regulation discussions in India often centre on whether small borrowers understand their loans. Lack of financial awareness can lead to over-indebtedness and greater economic vulnerability for the very clients that microfinance seeks to help. Indeed, the voluntary code of conduct developed by Sa-Dhan* after the Andhra Pradesh crisis in 2005 recommends that MFIs be fully transparent in the communication of loan details and interest rates. Thus, financial literacy has become a key policy focus in microfinance. However, to be fully transparent, MFIs must provide information that borrowers understand. The CMF’s Loan Contract Information Study analyses how MFI clients understand their loan contracts and how this should influence the definition of an informed MFI client. Moreover, this study goes a step further by exploring how client understanding should affect regulation on MFI transparency.

Methodology

For this study, we randomly surveyed two hundred first-time borrowers to gauge their understanding of their loan contract. Those surveyed received loans from two Indian microfinance institutions, one located in the north (Sonata, Allahabad) and one located in the south (BSS, Bangalore).

Findings

a) What clients already know

A large majority of respondents know about the following three components of their loans:

1) Loan amount 2) Loan duration 3) Weekly repayment amount
When first analysing the respondent replies, the numbers inititally indicate that only 43% of the respondents accurately stated their weekly repayment amounts. This number is misleading because one of the MFIs in our study collects Rs. 12 from its clients over and above the loan payment for member savings and insurance. When this amount is added to the weekly interest payment, the total number of respondents able to correctly state their weekly loan payment rises to 66%. Also, about 85% of respondents are very close (within 10%) to correctly stating how much they need to repay weekly. The tables below demonstrate which loan contract components microfinance clients understand:

Table 1.1 Client Understand of Loan Contracts (n=200)
Question % Correct % Incorrect
What is the amount of your loan? 96.5% 3.5%
What is the duration of your loan? 89% 11%

 

Table 1.2 What is the weekly installment on your loan, as written in your contract?
(n=200) As written in loan contract Adjusting for collection of savings (Rs 12) in the South Within 10% of weekly amount
Right Answer 42.5% 66% 84.5%
Wrong Answer 52% 28.5% 10%
Tried, but does not know 0.0% 0.0% 0.0%
Did not try and does not know 1.5% 1.5% 1.5%
Blank 4% 4% 4%

b) What clients do not know

As shown in the table below, clients are unable to accurately report interest on their loans, either as a percentage or as a Rupee amount. They are also unable to correctly recall the total interest paid on the loan. In other words, clients do not understand how much, in total, they pay for their loan. Interestingly, despite this lack of understanding, almost 47% of the respondents said that low interest rate was the reason why this source of credit was picked over others.

Table 1.3: What is the total interest that you are required to pay on this loan? (n=200)
Right answer 13.5%
Wrong answer 18.5%
Tried, but did not know 16%
Did not try and does not know 21%
Blank 1%

c) Client perspectives on collection practices

The table below shows reactions from respondents to four hypothetical situations in which MFI staff use coercive collection practices to enforce repayment. Interestingly, in all except the third scenario, the most popular answer choice out of the three options (Yes, No, Don’t Know) was ‘Yes, it’s all right.’

Table 1.4 Scenarios
Scenario Action deemed appropriate by respondents (%) (n=200)
Lakshmi is not able to pay her loan and the centre manager insists on holding the meeting outside her house. What do you think about the centre manager's action? 42%
If Lakshmi doesn’t repay her loan in your group, do you think it is appropriate to extend the meeting for another 30 minutes to enforce repayment? 45%
If Lakshmi doesn’t repay her loan in your group, do you think it is appropriate to extend the meeting for another 3 hours to enforce repayment? 33%
Lets say that Lakshmi does not repay her loan. Would it be okay for the MFI to take any of her assets, such as a cow she owns, her house, her land or machinery she uses? 54%

Policy Implications

This data provides insights that help answer the question of what it means for an MFI client to be informed. In this study, we find that the majority of small borrowers:
• Are able to identify loan size, duration and the weekly installment on their loan;

• Recognise that default can lead to adverse consequences; and

• Know very little about the interest rate and total interest expense on the loan.

However, this study, while useful for understanding how small borrowers perceive their loans, is limited in scope. As a next step, CMF plans to survey borrowers that receive loans from formal banks to see whether these borrowers understand loans in a similar or different manner than MFI clients. Such information could help regulators develop broader policies for financial institution transparency. Low-income borrowers understand loan liability in terms of weekly repayments, rather than in terms of interest rates, whose disclosure is usually the focus of regulation. While the study’s sample size is too small to make definitive conclusions
regarding regulation, the results strongly suggest that regulators should start from the borrower’s perspective and construct policies that require financial institutions to provide information to clients which they can understand and use. This type of bottom-up financial regulation, in which policymakers leverage knowledge of how small borrowers understand and use loan contract information, will help any new policy achieve its goal of protecting clients.


* Sa-Dhan is an association of microfinance institutions in India. The voluntary code of conduct is available here:

http://www.sa-dhan.net/corevalues.pdf

  
 
 

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