Interest rates

If you use someone else’s money, you must pay interest on the amount you have borrowed. Interest rate refers to the percentage of interest that the lender (a bank or MFI) charges.

It is important to make a distinction between simple and compound interest which many MFIs will charge. Below you can find some illustrative examples.

Simple interest

Example #1 – Loan  

Loan amount: $1000

Interest Rate: 10%

Interest: $100 x paid from the customer, to the bank, for using their money.

In the same way, when you put your money into a savings account at a bank, they pay you interest to store their money, although as you will soon discover, it is often at a far lower interest rate.

Example #2 – Savings account

Amount in savings account: $1000

Interest Rate: 5%

Interest: $50 x paid to the customer, from the bank, for holding their money

The above examples illustrate the total interest calculated over a single year, as most interest rates are calculated per year. However, it is often not this simple, as most loans will stretch beyond a one-year period.

Compound interest

This is where a borrower pays interest on the amount borrowed, PLUS any interest that has been added. The following two examples highlight the difference between simple and compound interest.

Example #3 – 2 year loan – simple interest

Loan amount: $1000

Simple Interest Rate: 10%

Loan Length: 2 years

Interest charged:  $200 ($100 year1, $100 year 2)

Example # - 2 year loan – compound interest

Loan amount: $1000

Compound interest rate: 10%

Loan Length: 2 years

Interest Charged: $210*

*year 1 = $100 ($1000 x 10%)

*year 2 = $110 (loan amount PLUS year 1 interest = 1100 x 10%)

Here, even though the interest rate (10%), the loan amount ($1000), and the term (2 years) are the same, the customer pays more in interest because it is compounded after the first year.

This distinction becomes even more critical because, quite often in microfinance, the interest rate is expressed per month, not per year. Therefore, the effect of compounding is greater, because it happens more frequently during the length of the loan.