Long Run-Effects of Repayment Flexibility in Microfinance: Evidence from India

As governments decide on the optimal regulation for the microfinance sector, key questions include the appropriate interest rate and repayment structure. This project investigates the benefits and costs of introducing greater flexibility into the classic repayment structure of microfinance institution (MFI) loans, which requires small installments starting immediately after loan disbursement. In 2007, Erica Field (Harvard), Rohini Pande (Harvard), John Papp (Princeton) and Natalia Rigol (MIT) partnered with the Village Financial Services (VFS), a MFI based in Kolkata, India, to run a randomized experiment to study the impact of greater flexibility on client outcomes. Clients were randomly assigned to either receive the classic MFI loan product with repayments starting immediately after loan disbursement or a loan product in which clients were given a two-month grace period before repayment began. The main findings of the research are as follows: Allowing clients a grace period before they begin repayment can help them invest a greater part of their loan into more profitable business activities. Results show that clients who were allowed a two-month grace period before beginning repayment invested nearly 9.4% more of their loan amount into their businesses compared to clients who were given the standard repayment schedule. Grace period clients also reported weekly profits from their businesses that were 30% higher on average than those without the grace period. This contributed to household incomes that were on average 16-19% higher for grace period clients. Greater flexibility in repayment schedules also raises default rates. The grace period allowed microfinance clients to invest in business activities that had significantly higher returns on investment, but that also carried greater risks. Partly driven by this increased exposure to business risk, the default rate on microfinance loans was higher among grace period clients: approximately 7% compared to 2% among clients without the grace period. We found that both the average level and variance of profits were significantly higher among grace-period clients, strengthening our perception that they were investing with greater risk and rewards. Therefore, greater flexibility in repayment seems to confer benefits to clients (higher profits) and potential costs to MFIs (greater defaults). A potential solution to achieve a better outcome for both MFIs and clients may be to offer a set of loan products with more flexible repayment and a higher interest rate while also retaining the current loan products with a traditional repayment schedule and lower interest rate. MFIs may also be able to lower transaction costs with flexible repayment by allowing clients to repay monthly rather than weekly, offsetting some of the cost of default from repayment flexibility. Decision-makers should consider the costs and benefits associated with greater flexibility of repayment schedules for both MFIs and clients. Although the results of this study may suggest that more flexible repayment schedules confer only benefits to microfinance clients, imposing repayment schedules and interest rates that are unsustainable for MFIs in the long-run could cause them to shut down, thereby decreasing the amount of credit accessible to the poor in developing countries.