Over the years, I have often been asked how MFIs price or set their interest rates for various loan products. I have developed a basic pricing model for MFIs with less than $5.0M in assets with the caveat that there are many variations to the formula depending upon local conditions and investor requirements. I am fully aware that in my 25+ year-MFI career, I have never met another MFI manager who approaches pricing in this manner and expect a lot of push back. However, my financial training and work experience have led to this basic model.
1. 15% of Total Assets = Annual Operating Expenses,
2. Plus 10% of Total Assets = Return-on-Assets or ROA,
3. (1+2) Divided (3-4) by 90% of Total Assets = Size of Loan Portfolio,
4. Delinquency of 5% of Total Loan Portofolio = Delinquency
5. Equals the rate of Interest for Product Pricing.
ASSUMPTIONS:
1. 15% of Total Assets = the ideal theoretical annual operating expenses for a small MFI based on CAMEL evaluation criteria.
2. 10% of Total Assets = recommended Return-on-Assets (ROA) before taxes for the MFI.
3. 90% of Total Assets = the ideal size of the outstanding loan portfolio with about 7% of assets in cash and 3% in fixed assets.
4. Delinquency of up to 5% of total loan portfolio is allowable with CAMEL and its variations. Remember that loans that are delinquency temporarily produce no interest revenue - more like dead assets.
EXAMPLE:
An MFI with $1,000,000 in Assets
1. Total expenses would be $150,000,
2. ROA would be $100,000.
3. Loan Portfolio would be $900,000,
4. Delinquency $45,000.
5. $250,000 divided by $855,000 = 29.24% rounded to around 30%.
Your product(s) should be returning around 30% per year.
SOME VARIATIONS:
1. Many MFIs have very high expenses because of inefficiencies. It is not uncommon to see 25% to 30% of Assets. In this case our example of a $1,000,000-MFI would have at least $250,000 in expenses.
2. Equity investors are now seeking 20% returns on equity (sometimes ROA) over a consistent 5-year basis. This will then up your ROA by 5% to 10% or an extra $50,000 to $100,000.
3. During the recession delinquencies are climbing to alarming levels. I've run across MFIs with 40% delinquencies. Play with this percentage in the formula to give yourself a heart attack.
4. You can then imagine how high your interest rates for products have to be.
5. One cannot simply keep raising interest rates. Expenses and ROA have to go down and loan volume has to be maintained. It's truly an art to get all the parts working in harmony.
Please play around with various scenarios to see how you can use this model for setting the base interest rates for products. Let me know if you come up with other variations or thoughts of how to improve the model. Thanks much.
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