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Keeping people honest: collateral in microfinance

- Matt

This post was from July 25th when I was traveling through Ghana working for a microfinance organization. Check out some of my other posts to get a better background.

How do you make sure people pay back their loans?

The first time I tried to talk to my Dad about microfinance, it didn’t go so well. We had sat down at a restaurant, just the two of us, for what I thought would be a nice relaxing meal (if you’re reading this Dad, I’m talking about Gatlinburg). Somewhere along the line, conversation drifted over to stuff I was working on and inevitably, microfinance came up. He had never fully understood the topic, so I explained the basics to him: impoverished people get access to credit, use the money to expand their businesses, and repay the money over time.

At that time, I thought that there was no way to argue against it. How could you have anything negative to say over helping people escape from poverty? My Dad being…..well, my Dad, he was able to immediately see a serious problem. What was the incentive for borrowers to repay their loans?

His question was spot-on, though because I wasn’t ready to admit it at first, it led to a lengthy debate. But I eventually realized he did have a good point. In a first world nation, if borrowers don’t pay back their loans on time, the bank can easily repossess their car or other belongings. But in third world nations, everything works a little differently. People don’t have many possessions, especially if they are in a position when they need a microloan. And the few possessions they have are often their only avenues to make money. For example, a family might rely on the profits earned from selling the milk of their only cow. You can’t ethically take away that cow when it is the only sustainable source of income for the family.

N’Dama cattle, a breed typical to Ghana

But on the flip side, you have to have some way of making sure people pay their loans back. If there’s no punishment, there’s no incentive. So how do we balance making sure loans are paid back with ethical considerations? We are trying to help people after all, not run them into debt.

The best way that microfinance institutions have found for keeping borrowers honest is making the borrower earn the lender’s trust. Borrowers will only receive small amounts of money at first, maybe $100-200, that has to be paid back in a short amount of time. When the borrower can show they are committed to repaying the loan, then they can apply for larger and larger loans. The borrower wants to get another loan, so the lender can use that incentive to keep the repayments flowing back.

And that strategy has been pretty effective. It is the way Kiva.org has kept their repayment rate at over 98%. Makes you think twice about how “risky” you might think loaning to people in third world nations might be.

Borrowers will pay their loans back. They just need the right incentives. And I need to stop arguing with my Dad. Those Yale grads are smarter than you think!

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