Interest does not increase financial returns

Discussion in 'Announcements' started by Julia Kurnia, Feb 18, 2015.

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  1. Julia Kurnia

    Julia Kurnia Director, Zidisha Zidisha Staff

    It has been about a year since we transitioned control of interest rates from borrowers to lenders, and we now have enough data to assess how the interest rates lenders choose affect the financial performance of their loan funds.

    Over the past few weeks, we have been working with data scientist Tracey Li to analyze the relationship between interest rates, repayment rates and financial sustainability for lenders. Given the assumption that higher interest rates increase financial returns on Zidisha loans, we wanted to identify more precisely the interest rate that, averaged over many loans, would be most likely to help lenders break even, without excessive profit or loss.

    The analysis yielded a surprising finding: higher interest rates were not, in fact, associated with higher financial returns for lenders. The reason is that the incidence of non-payment increased when higher interest was charged, and even at the higher rates, the interest income from the repaid loans was not sufficient to compensate for the greater amount of principal lost to non-payment. In fact, the value of lending funds after interest payments was preserved best at 0% interest, and losses were highest for the loans that had the highest interest rates.

    This finding holds true for Zidisha's five years of history in aggregate, as well as over the past year when interest rates have been set by lenders without input from the borrowers. It holds true for both first-time borrowers, and repeat borrowers: all else being equal, individuals were more likely to repay loans that carried lower interest rates, and the difference in repayment rates was substantial enough to override the difference in interest income.

    Both the the data scientist and I performed multiple checks of the data, using different methods, in order to be certain of the conclusion: For loans at Zidisha on average, applying higher interest rates has not increased the value of lending funds, and may be counter-productive.

    The main purpose of interest at Zidisha has been to help lenders preserve the value of their lending funds. Since a substantial body of data now show that interest has not fulfilled its intended purpose, it is our responsibility to share these results, and to adjust our service in response.

    Starting this month, we will be piloting an alternative approach to loan fund sustainability: Instead of paying interest over the course of each loan, new borrowers will be asked to pay a larger membership fee at the time they raise their first loan. The fee ranges from about $12 to $40 depending on the country. (It is highest for the fast-growth countries of Kenya and Ghana, and temporarily reduced or waived in other countries where membership numbers are still small, in order to facilitate early growth in those locations.) It is only paid once (for lifetime membership), and only in the event that a loan is successfully funded and disbursed.

    In the event one of the zero-interest loans defaults, we will use funds from the membership fee pool to reimburse lenders, up to a maximum of $1,000 per lender, as long as funds are available. Since this is subject to funds availability and does not cover currency exchange rate losses, it is not an insurance policy and does not eliminate risk. Zidisha is a philanthropic platform, not a place to store financial assets, and as always, we recommend lending no more than you would be prepared to give away to charity. The intent is simply to do our best to help lenders preserve the value of their lending funds over time, not to make lending accounts a risk-free place to keep one's money.

    How will the reimbursements work? Here is the way they are currently programmed in our website:
    • When a new borrower joins, a Loan Loss Reserve fee payment will be due after his or her first loan is fully funded. The payment must be made before the first loan is disbursed. This fee is only paid once, at the time a new borrower joins; it is not paid for each loan.
    • Once received, the payment goes into a Loan Loss Reserve account. The funds in this account will be used exclusively to reimburse lenders for loan losses.
    • In the event that one of the zero-interest loans falls into arrears (defined as more than ten days overdue, by an amount greater than $5 or greater than the value of one repayment installment, whichever is lesser) a "Receive early repayment" button will appear in the "Your Loans" page if the following two conditions are true:
      • There are sufficient funds remaining in the Loan Loss Reserve account.
      • You have not received more than $1,000 in Loan Loss Reserve payments in the past.
    • If you click the "Receive early repayment" button, you will receive a refund for the full dollar amount you contributed to the loan, minus any repayments you have already received.
    The intent is that the amounts refunded to lenders are as close to possible to the amounts paid by borrowers. In order to achieve this balance, we may adjust parameters such as the amount paid by borrowers, the lateness threshold at which refunds will be available, or whether lenders are refunded automatically instead of opting in. However, the overall structure will remain the same for these loans.

    We believe shifting borrower costs to the initial membership fee will have several advantages:
    • It increases the financial incentive to repay, once a borrower has joined Zidisha.
    • It makes joining Zidisha less attractive to anyone who does not intend to repay, because most of the financial benefit is deferred to later loans.
    • Taking interest out of the picture may improve the relationship between lenders and borrowers.
    • It may make participation more attractive for lenders, who commonly report choosing an interest rate to be a less enjoyable aspect of funding a project.
    • It makes cost of loans more predictable for borrowers.

    That said, we will monitor performance carefully during the pilot. If the expected benefits do not materialize, or there are unexpected problems, we will reevaluate. In the event we decide not to continue the pilot, the offer to reimburse lenders for defaults of the zero-interest loans made during the pilot will still be valid.


    Notes:

    You may read an overview of the data science project here: https://tcl270.github.io/

    Below is an illustrative subset of the data, depicting the changes in loan fund values for Kenya loan amounts that were due to be repaid six months ago or more, for the loans that were disbursed in the past year. The Change in Loan Fund Value is calculated as the difference between the principal that was due to be repaid during the period, and principal + interest that has been repaid to lenders.

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    Last edited: Mar 6, 2015
  2. K M

    K M Gold Member

    Under this new system, how does Zidisha intended to distinguish itself from other micro loan platforms which offer lenders no interest, such as Kiva Zip?

    Will direct communication between lenders and borrowers be enough?

    There may be no interest going to the lender, but it seems to me that Zidisha itself will be extracting what is in effect a 40% interest on some borrowers for their first loan, assuming that the new borrower is joining by invitation and getting a $100 loan. Is the $50 first loan for non-invitees being abandoned? How is it fair to borrowers in Kenya and Ghana that they should pay a considerable fee, when someone in a lower-membership country does not? I see no justification for this. If there is to be a higher membership fee, surely it should be applied equally to all new borrowing members.
     
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  3. qt9998

    qt9998 Gold Member

    Will Zidisha still be charging 5% interest?

    Will this $40 registration fee be deducted from the $100 loan amount before disbursement, meaning borrowers will only receive $60 but are expected to pay back $100 + 5%?

    With no interest to pay to lenders, what will discourage these borrowers from rescheduling repayment of their loans far into the future? By doing so, they would avoid default
    and no reimbursement from the membership pool to lenders would be necessary.
     
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  4. KirstenShute

    KirstenShute Gold Member

    An interesting conclusion, and it seems like there's good research behind this. (I'll show this to my programmer friend; she does a few projects on GitHub herself.)

    @K M - I'm not sure; perhaps there's more competition for Zidisha loans in those countries and people are more willing to pay a higher fee? In that case it would make sense, though it seems to me spreading out the costs would be fairer to individual borrowers ($20-25 flat, say, for everyone).
     
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  5. qt9998

    qt9998 Gold Member

    @K M, looks like $50 first loans are still being accepted for funding.

    The 0% interest has been implemented across the board, meaning that prior borrowers who did not pay the new registration fee can apply for large 2nd/3rd loans at 0% interest.

    The FAQ has not been changed to reflect any of this.
     
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  6. jmakongo

    jmakongo Silver Member Volunteer Mentor

    sounds good and better, but my question is, why do zidisha has to keep the 5% instead of also adjusting or doing away with it since its non profit, lets assume i borrowed $1000 its 5% is about %50 of which zidisha says its for transation, sending funds to mpesa here in kenya,lets assume you are sending me 90,000, of which that will cost about ksh300 to 600 here zidisha takes ksh4,550 as its 5% for transaction, where will the rest go since it has no employments?
     
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  7. Roy

    Roy Gold Member

    I suggest the different treatment of different countries should reflect the different circumstances. If one wants to put it in terms of “fairness”, it is an attempt to make what is unfair fairer.
     
    Oscar Alochi likes this.
  8. Roy

    Roy Gold Member

    The fact that the “drop down selection” for interest still features, but does not function is misleading may be the reason why people are having difficulties understanding the treatment of interest. I also understand the “FAQs” have not been updated....


    Best Regards,
     
  9. tony

    tony Gold Member Volunteer Mentor

    Thank you for the information. This is one reason why Zidisha is such a great place because one understands what's going on. Today, I had a call from an applicant seeking my assistance because he got 1500 KES (approx.) after applying for about 4500 KES (He gave me the rough figures). I didn't have a direct answer for him until now (I am a VM). I think a number of borrowers have not realized the new reality and those who noted have not come to terms with it.
     
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  10. Roy

    Roy Gold Member

    Julia wrote in the opening message of this thread: "In the event one of the zero-interest loans defaults, the intent is to use funds from the membership fee pool to reimburse lenders, up to a maximum of $1,000 per lender, as long as funds are available."

    In addition to that provision, Zidisha management must ensure there are sufficient funds to ensure the service continues. While most people working for the organization, are volunteers, some people will on occasions need to travel. I don't think you can expect them to not only give their time but pay for their travel expenses. There are on occasions needs for professional services, which while needed volunteers may not have the time to deliver the service at the time needed. There are costs to cover the computer server(s), which is needed....The list goes on... And as I wrote, management must ensure sufficient funds are there to continue this wonderful service.
     
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  11. Julia Kurnia

    Julia Kurnia Director, Zidisha Zidisha Staff

    KM, we share your concerns and thought about them a great deal. Interest was never intended to be the main distinguishing feature of Zidisha. Rather, our main distinguishing features were intended to be lower cost to the borrower, and direct communication.

    Interest was intended to be a means to an end: helping lenders preserve the value of their lending funds over the long term. When enough data became available to draw robust conclusions, it became clear that interest was not serving its intended purpose, while having obvious costs to borrowers, and (to the extent that higher interest reduces financial returns) costs to lenders, as well. Now that this is known, it would not be right to continue to structure the loans in a way that does not benefit our members.

    I agree that if the lifetime membership fee were interpreted as the fee for a single loan, especially the small first-time loans, it would be so exorbitant as to defeat the purpose. But when spread over a lifetime of unlimited successive loans, a $40 fee is very low indeed. (Of course, if a member defaults on the first loan, it is a poor deal, but that is deliberate. The intent is that individuals who know they will not repay well enough to qualify for a large number of loans will not find our service attractive.)

    The intent is that over the long term, the membership fee will be roughly equal for all countries. In countries where Zidisha is still new, we temporarily waive or reduce the membership fee in order to encourage growth. Once Haiti, Guinea and other underrepresented countries have a large number of borrowers and are growing strongly, they will no longer need this help and we can apply the same fees as the others. This helps counter-balance the tendency for the largest memberships to grow faster than the smallest memberships, and ultimately leads to more diversity which is in the interest of all members.
     
    Last edited: Feb 23, 2015
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  12. Julia Kurnia

    Julia Kurnia Director, Zidisha Zidisha Staff

    Yes, we will still apply the 5% fee. If we did not, we would not have the resources to cover international money transfer fees, SMS fees, and other costs needed to operate the service.

    It is true that reducing interest reduces the financial cost of lengthening repayment periods. It is possible that this will result in loans being held for longer, and we are monitoring borrowers' repayment period choices carefully. That said, our experience is that the majority of borrowers desire to repay their loans as quickly as they can, not to save on interest but in order to raise new loans to further grow their businesses. Repayment speed is driven more often by fluctuations in borrowers' cash flows (often beyond the borrower's control) than small differences in interest cost.
     
    Last edited: Feb 24, 2015
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  13. Julia Kurnia

    Julia Kurnia Director, Zidisha Zidisha Staff

    Roy, I apologize for the confusing presentation of information. I am responsible for the user-facing parts of the website. I had intended to update the website language and drop-down menu immediately when the interest rate change became effective, but my computer broke down and I was only today able to get a replacement one working. (I am traveling in Indonesia, so cannot easily buy a new one.) Clarifying the interest rate language will be the top priority once the web development software is operational on the replacement computer, which should be tonight or tomorrow if the internet connection continues to work.
     
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  14. K M

    K M Gold Member

    I'm curious to see how this works out! It certainly seems to have boosted the number of borrower applications.
     
  15. Marto

    Marto Sky is the limit Volunteer Mentor

    In layman's language, the registration fee for Kenyans has gone up from Kshs. 1,000 to Kshs. 3,000. For first time appliers, you will pay around Kshs. 4,500 but you will receive only Kshs. 1500, right? However, do all other aspects of the loan remain the same?
     
  16. Julia Kurnia

    Julia Kurnia Director, Zidisha Zidisha Staff

    Hi Marto,

    All other aspects of the loan remain the same, except there is no longer an interest cost - only a service fee of 0,42% per month (5% per year) the loan is held. Essentially, more of the cost is being shifted away from future loans, and instead paid in the beginning.

    This change is a financial disadvantage for anyone who does not repay their early loan(s) responsibly, as they do not qualify for the larger future loans where most of the cost savings occur. It increases the financial reward for members who repay responsibly and go on to raise large loans.

    The intent is that this cost structure will be attractive only to responsible people who know they will be raising loans with us over the long term.

    Best,

    Julia
     
  17. Julia Kurnia

    Julia Kurnia Director, Zidisha Zidisha Staff

    Yes, we've had a record number of applications recently. The number of projects fundraising surpassed 500 for the first time in our history last week. The total volume of loans funded has been growing, but borrower demand has gone up even faster.

    The majority of these applications were posted before the interest rate change, though. I believe the main driver of this growth has been recent improvements to the borrower interface in our website, which have made it easier to complete the registration and loan application forms. We also made the option to invite new members (for borrowers with good repayment records and good past invitee repayment records) more prominent and user-friendly.

    It is too early to be certain how substituting membership fees for interest will work out. Some of the metrics we are watching closely are:
    • Lender participation. Thus far, removing interest has not reduced lending activity in aggregate. Non-automated lending is actually slightly increased in the several days since we made the change - but not enough time has passed to be certain of the long-term impact.
    • Borrower participation. Will the higher registration fee deter too many new borrowers from joining? New borrower signups have decreased by about 10% in the past several days - about what we had anticipated.
    • Financial sustainability. Will the loan loss reserve funded with the new member registration fees be sufficient to cover defaults? It is set at a level that, if past trends continue, would be sufficient to cover the average principal loss (i.e. the loss that would have occurred without any interest payments) per borrower. However, Zidisha is still too new to be certain that past trends will continue.
    • Loan repayment speed. Will removing interest cost cause borrowers to hold their loans for too long?
    • Repayment rates. Past data suggests a correlation between reducing interest rates and increasing repayment rates, but this does not prove that removing interest will cause repayment rates to increase in aggregate. Our projections assume (to be conservative) that repayment rates for the zero-interest loans will remain similar to those of 2014.
     
    Last edited: Feb 24, 2015
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