1. Chapter-5
Designing Lending Products
Cash pattern: To design a loan product to meet borrower needs, it is important to
understand the cash patterns of borrowers. Cash patterns are important in so far as they affect the
debt capacity of borrowers. Lenders must ensure that borrowers have sufficient cash inflow to
cover loan payments when they are due. While analyzing the cash pattern one should analyze the
following cash pattern:
Cash inflows are the cash received by the business or household in the form of wages, sales
revenues, loans, or gifts.
Cash outflows are the cash paid by the business or household to cover payments or purchases.
Some cash inflows and outflows occur on a regular basis, others at irregular intervals or on an
emergency or seasonal basis. Seasonal activities can create times when the borrower generates
revenues (such as after a harvest period) and times when there is no revenue (revenue may be
received from other activities). However, loan terms often extend over several seasons, during
which there can be gaps in revenues.
Loans should be based on the cash patterns of borrowers and designed as much as
possible to enable the client to repay the loan without undue hardship.
This helps the MFI avoid potential losses and encourages clients both to manage their
funds prudently and to build up an asset base. (This does not mean that only cash flows
from the specific activity being financed are considered; all cash flows are relevant.)
The appropriate loan amount is dependent on the purpose of the loan and the ability of
the client to repay the loan (that is, debt capacity). When determining the debt
capacity of potential clients, it is necessary to consider their cash flow as well as the
degree of risk associated with this cash flow and other claims that may come before
repayment of a loan to the MFI.
Adjusting the debt capacity of a borrower for risk should reflect reasonable expectations
about adverse conditions that may affect the borrower’s enterprise. Adjustment for
adversity has to reflect the lender’s willingness to assume the risks of borrowers’
inability to repay. The greater the MFI’s capacity to assume risk, the higher the credit
limits the lender can offer.
Often MFIs have a maximum loan size for first-time borrowers, which increases with
each loan. This is designed both to reduce the risk to the MFI and to create an incentive
for the clients to repay their loans (namely, the promise of a future larger loan). In
addition, increasing loan sizes enable the client to develop a credit history and an
understanding of the responsibilities associated with borrowing.
2. How Does the Loan Term Affect the Borrower’s Ability to Repay?
Loan term: It refers to the period of time during which the entire loan must be repaid. The loan
term affects the repayment schedule, the revenue to theMFI, the financing costs for the client,
and the ultimate suitability of the use of the loan. The closer an organization matches loan terms
to its client’s needs, the easier it is for the client to “carry” the loan and the more likely that
payments will be made on time and in full.
The following example provides three alternative loan terms with installment payments:
For example, Miss Jyoti a dressmaker purchases cloth and supplies every four months to benefit
from bulk purchasing, resulting in a four-month business cycle. Her net revenue over the four
months (after purchasing supplies for 1,000 and incurring all other expenses but
before loan repayment) is 1,600 (400 per month).
ALTERNATIVE 1: Four-month loan matching her business cycle. She borrows 1,000 for four
months at 3 percent monthly interest, with monthly payments of 269 (calculated on the declining
balance method). Her total payments are then 1,076 (interest expense of 76). Revenue of 1,600
less the loan repayment of 1,076 leaves her a net income of 524.
Cash flow over the four months is as follows:
Period Business Loan Income
0 (1000) 1000 -
1 400 (269) 131
2 400 (269) 131
3 400 (269) 131
4 400 (269) 131
Total 600 (76) 524
In this scenario, the dressmaker has extra income to consume or reinvest as additional working
capital if she chooses. The loan term is appropriately matched to her business cycle and cash
flow patterns.
ALTERNATIVE 2: Two-month loan shorter than her business cycle. She borrows 1,000 for two
months at 3 percent per month with monthly payments of 523 and sales of 400 per month. Total
payments are 1,046 (interest expense of 46). Revenue of 1,600 less the loan repayment of 1,046
leaves 554.
Cash flow is as follows:
Period Business Loan Income
0 (1000) 1000 -
1 400 (523) (123)
2 400 (523) (123)
3 400 - 400
4 400 - 400
Total 600 (46) 524
3. With a two-month loan term and a four-month business cycle, the borrower does not generate
enough revenue in the first two months to make the loan payments. If she had no savings to
begin with or no access to other income or credit to support the loan payments, she would not
have been able to repay the loan.
ALTERNATIVE 3: Six-month loan longer than her business cycle. She borrows 1,000 for six
months at 3 percent per month with monthly payments of 184.60 and sales of 400 per month for
four months only. (Assume that because she does not have a full 1,000 built up in working
capital at the end of the four months, she cannot buy more inventory at the “bulk purchase” price
and thus has two months of no income While this may not always be realistic, it is presented here
to illustrate the fact that in some circumstances longer loan terms are detrimental to the
borrowers, particularly if they cannot access future loans until the existing loan is paid back.)
Total payments are 1,107.60 (interest expense of 107.60). Revenue of 1,600 less the loan
repayment of 1,107.60 leaves 492.40.
Cash flow is as follows:
Period Business Loan Income
0 (1000) 1000 -
1 400 (184.6) 215.6
2 400 (184.6) 215.6
3 400 (184.6) 215.6
4 400 (184.6) 215.6
5 0 (184.6) (184.60)
6 0 (184.6) (184.60)
Total 600 (107.6) 492.40
In this scenario the cash flow in the first four months is easier for the borrower; however, she
may be tempted to spend the higher net income in the early months of the loan, resulting in
potential difficulty making loan payments during the last two months. She also has less net
income due to the greater amount of interest paid.
This example illustrates why 12-month loans in busy urban markets often result in delinquency
and defaults toward the end of the loan term. Also, the borrower ends up being underemployed
for two months, because she does not have access to credit to buy more inventory. If the loan
term were shorter and she was thus able to borrow again, she could continue to be fully engaged
in her business.
The preceding three alternatives demonstrate that cash flow in part determines the debt-servicing
capacity of borrowers. This influences the appropriate loan terms and loan amounts, which in
turn determine the debt-servicing requirements. MFIs should design the loan terms and loan
amounts to meet the debt-servicing capacity of their clients. This becomes less of a concern the
more profitable the business becomes because greater revenue can potentially result in enough
additional income to build up sufficient savings, so that the client no longer needs to borrow
unless she or he wants to expand the business. (In such a case the MFI has successfully improved
the economic position of its client and should not consider this client “drop out” to be negative or
indicative of poor service or products.)
4. Depending on cash patterns and loan terms, clients may at times prefer to prepay their loans.
Prepayments have two major advantages for the client.
They can reduce both the security risk and the temptation to spend excess amounts of
cash.
They can reduce the burden of the loan installments later in the loan cycle.
Prepayments result in one clear advantage for an MFI: by having the loan repaid earlier, the MFI
can revolve the loan portfolio more quickly and thereby reach more clients.
However, prepayments are difficult to monitor, and if they are significant they can disrupt the
cash flow of an MFI (or its branches). This may affect the ability to accurately predict cash flow
requirements. In some MFIs full loan repayment results automatically in a larger loan
to the client. This may result in the MFI having reduced funds available to lend to other clients.
In addition, when interest is calculated on the declining balance, a prepayment usually includes
the principal owing and any interest due up to the amount of the prepayment.
This means that when loans are prepaid, less interest revenue is received than initially forecast,
resulting in decreased income for the MFI (unless the funds can be immediately lent out again).
If a particular subset of borrowers (for example, market vendors) tend to prepay their loans on a
regular basis, it is advisable to shorten the loan term to suit the needs of that client group. Loan
terms should be designed to minimize the need for prepayments. This involves matching
the loan term to the cash patterns both to help clients budget their cash flows and to lower the
likelihood of prepayments or delinquency.
Finally, prepayments can also indicate that borrowers are receiving loans from another lender,
which may be providing better service, lower interest rates, or more appropriate terms. If this is
the case, the MFI needs to examine its loan products and those of other lenders.
Payments Frequency:
Loan payments can be made on an installment basis (weekly, biweekly,
monthly) or in a lump sum at the end of the loan term, depending on the cash
patterns of the borrower. For the most part, interest and principal are
paid together.
However, some MFIs charge interest up front (paid at the beginning of the loan term) and
principal over the term of the loan, while others collect interest periodically and the principal at the
end of the loan term.
Activities that generate ongoing revenue can be designed with installment payments. In this way
the client is able to repay the loan over time without having to save the loan amount (for
repayment) over the term of the loan
The frequency of the loan payments depends on the needs of the client and the ability of the MFI
to ensure repayment. Some moneylenders collect payments every day, particularly if their
borrowers are market vendors receiving cash on a daily basis. Other lenders collect on a monthly
basis, because they are not conveniently accessible to the borrower (that is, the bank branch is
located far from the borrower’s business). A balance must be reached between the transaction
costs associated with frequent payments and the risk of default through poor cash management
associated with infrequent repayments.
5. For seasonal activities, it may be appropriate to design the loan such that a lump sum payment is
made once the activity is completed. Harvesting activities is a good example.(Note that other
household income can be used to repay the loan in small amounts.) However, caution mustbe
exercised with lump sum payments, particularly if there is risk that the harvest (or other seasonal
activity) may fail.
If when the loan is due there is no revenue being generated, the risk of default is high. Some
MFIs that finance seasonal activities design their loans with installment payments so that at
harvest times the borrowers keep most of their harvest revenue, because the majority of the loan
has already been repaid by the end of the harvest. This works to increase the savings (assets) of
borrowers.
MFIs may also combine installment loans with lump sum payments, collecting a minimal amount
of the loan (for example, interest) over the loan term, with the remainder paid at the end of the
harvest season (the principal).
Working Capital and Fixed Asset Loans:
The amount of the loan and the appropriate loan term are affected by what the loan will
be used for. There are generally two types of loans—working capital loans and
fixed asset loans.
Working capital loans are for current expenditures that occur in the normal course of
business. Working capital refers to the investment in current or short-term assets to
be used within one year. Examples are wood purchased for carpentry, food or goods
purchased for market selling, or chick feed purchased for poultry rearing. A loan
made for working capital should have a loan term that matches the business cycle of
the borrower (as described above). Working capital loans from MFIs are generally
for two months to one year.
Fixed asset loans are those made for the purchase of assets that are used over time in
the business. These assets typically have a life span of more than one year. Fixed
assets are usually defined as machinery, equipment, and property. Examples of fixed
assets include motorcycles, sewing machines, egg incubators, or rickshaws.
Since the productive activity does not directly use up the fixed asset (that is, not sold
as part of the product), its impact upon profitability is felt over a longer period of time. A
loan made for a fixed asset is generally for a larger amount and for a longer term than
a working capital loan (that is, fixed asset loans do not necessarily match the business
cycle). This results in higher risk for an MFI, offset somewhat if the organization takes
legal title of the purchased asset as collateral. Table 5.1 provides examples of loan
uses for working capital or fixed assets. Although longer loan terms may be required
for fixed asset purchases, some MFIs find that they do not need to introduce special
loan products if they are relatively inexpensive and the loan can be repaid over 12
months or less.
More and more often MFIs are acknowledging the fungibility of money, that is, the
ability at various times to use funds borrowed for a certain activity for other
6. household expenses. Accordingly, the purpose of the loan is not as important as the
borrower’s capacity to repay it.
Loan Collateral
Generally, MFIs lend to low-income clients who often
have very few assets. Consequently, traditional collateral
such as property, land, machinery, and other capital
assets is often not available. Various innovative means
of reducing the risk of loan loss have been developed,
including collateral substitutes and alternative collateral.
Collateral Substitutes
One of the most common collateral substitutes is peer
pressure, either on its own or jointly with group guarantees
(see chapter 3). In addition, there are other frequently
used forms of collateral substitute.
GROUP GUARANTEES. Many MFIs facilitate the formation
of groups whose members jointly guarantee each other’s
loans. Guarantees are either implicit guarantees, with
other group members unable to access a loan if all members
are not current in their loan payments, or actual
guarantees, with group members liable if other group
members default on their loans.
Some MFIs require group members to contribute to
a group guarantee fund, which is used if one or more
borrowers fail to repay. Use of the group guarantee fund
is sometimes at the discretion of the group itself and
sometimes decided by the MFI. If it is used at the
group’s discretion, the group will often lend money
from the guarantee fund to the group member who is
unable to pay. The member who “borrows” from the
group fund is then responsible for paying the fund back.
If use of the group guarantee fund is managed by the
MFI, the fund is seized to the extent of the defaulted
loan, with other group members making up any shortfall.
Failure to do so means that the entire group no
longer has access to credit.
CHARACTER-BASED LENDING. Some MFIs lend to people
based on a good reputation in the community. Prior to
making a loan the credit officer visits various establishments
in the community and asks about the potential
client’s character and behavior.
FREQUENT VISITS TO THE BUSINESS BY THE CREDIT OFFICER.
Provided the branch or credit officers are within a reasonable
geographical distance from their clients, frequent visits
help to ensure that the client is maintaining the business
and intends to repay the loan. Frequent visits also allow
the credit officer to understand her or his clients’ businesses
and the appropriateness of the loan (amount, term, frequency
of payments, and so forth). Visits also contribute
to developing mutual respect between the client and the
7. credit officer as they learn to appreciate and understand
each other’s commitment to their work.
RISK OF PUBLIC EMBARRASSMENT. Often clients will
repay loans if they feel that they will be embarrassed in
front of their family, peers, and neighbors. This would be
the case if public signs, notices printed in the local newspaper,
or announcements made at community meetings
list borrowers who do not repay.
RISK OF JAIL OR LEGAL ACTION. Depending on the legal
context in a country, some MFIs have sued or, in rarecases, even jailed clients for nonpayment.
Sometimes,
simply the risk of legal repercussion is enough to encourage
repayment.
Alternative Forms of Collateral
There are at least three commonly used alternative forms
of collateral.
COMPULSORY SAVINGS. Many MFIs require clients to
hold a balance (stated as a percentage of the loan) in savings
(or as contributions to group funds) for first or subsequent
loans (or both). Compulsory savings differ from
voluntary savings in that they are not generally available
for withdrawal while a loan is outstanding. In this way
compulsory savings act as a form of collateral.
By being required to set aside funds as savings, borrowers
are restricted from utilizing those funds in their business
activities or other income producing investments.
Usually the deposit interest rate paid (if any) on the savings
is lower than the return earned by the borrowers if
the savings were put into their business or other investments.
This results in an opportunity cost equal to the difference
between what the client earns on compulsory
savings and the return that could be earned otherwise.
Compulsory savings can have a positive impact on
clients by smoothing out their consumption patterns and
providing funds for emergencies provided the savings are
available for withdrawal by the borrower. Most compulsory
savings are available for withdrawal only at the end of
the loan term, providing the loan has been repaid in full.
Clients thus have additional cash flow for investment or
consumption at the end of the loan term. Compulsory
savings also provide a means of building assets for clients;
not all MFIs view compulsory savings as strictly an alternative
form of collateral.
A variation of compulsory savings required by Bank
Rakyat Indonesia is for borrowers to pay additional
interest each month, which is returned to them at the
end of the loan provided they have made full, on-time
payments each month. This is referred to as a “prompt
payment incentive” and results in the borrower receiving
a lump sum at the end of the loan term. This benefits
the borrower and provides a concrete incentive to repay
the loan on time, thus benefiting the bank as well.
Compulsory savings also provide a source of lending
and investment funds for the MFI. They are generally a
stable source of funds because they are illiquid (that is,
savings are not generally available for withdrawal by the
8. borrowers while their loans are outstanding). However,
it is essential that the MFI act in a prudent manner when
on-lending or investing client savings to ensure that the
funds will be repaid and can be returned to the client in
full when necessary.
ASSETS PLEDGED AT LESS THAN THE VALUE OF THE LOAN.
Sometimes, regardless of the actual market value of
assets owned by the borrower, the act of pledging assets
(such as furniture or appliances) and the consequent
realization that they can be lost (resulting in inconvenience)
causes the client to repay the loan. It is important
that the MFI formally seize the assets that have
been pledged if the client does not repay the loan. This
sends a message to other borrowers that the MFI is serious
about loan repayment.
PERSONAL GUARANTEES. While microborrowers themselves
do not often have the ability to guarantee their
loans, they are sometimes able to enlist friends or family
members to provide personal guarantees (sometimes
referred to as cosigners). This means that in the event of
the inability of the borrower to repay, the person who
has provided a personal guarantee is responsible for
repaying the loan.
Many of the foregoing collateral substitutes and alternative
forms of collateral are used in combination with
each other. A good example of this is offered by the
Association for the Development of Microenterprises
(ADEMI) in the Dominican Republic (box 5.1).
Loan Pricing
Pricing loans is an important aspect of loan product
design. A balance must be reached between what clients
can afford and what the lending organization needs to
earn to cover all of its costs. Generally, microfinance
clients are not interest-rate sensitive. That is, microentrepreneurs
have not appeared to borrow more or less in
reaction to an increase or decrease in interest rates. For
the most part, an interest rate far above commercial bank
rates is acceptable because the borrowers have such limited
access to credit. However, an MFI must ensure that
its operations are as efficient as possible so that undue
burden is not put on its clients in the form of high interest
rates and fees
MFIs can determine the interest rate they need to
charge on loans based on their cost structure. MFIs incur
four different types of costs:
Financing costs
Operating costs
Loan loss provision
Cost of capital.
Each of these costs are discussed further in part III
when adjustments to the financial statements are made
and when determining the financial viability of MFIs. For
specific information on how to set a sustainable interest
rate based on the cost structure of anMFI, see appendix 1.
9. In general, an MFI incurs relatively low financing
costs if it funds its loan portfolio primarily with donated
funds. However, if compulsory savings (discussed above)
are used to fund the loan portfolio, they can affect the
