Microfinance is much talked about these days. Among the umpteen issues being debated, borrowers’ debt trap is the most disturbing. The heart-wrenching subject, which came to light during the investigation of borrowers’ suicides, is not due to the high interest rate, but the perils of over-borrowing. The risk to a household arises from taking a debt that is much beyond its ability to repay. It is a trap that both urban and rural households are prone to.
Borrowing is not an evil in itself. Most households are unable to correctly match their incomes and expenses month-after-month. There are huge expenses to be incurred, and borrowing is to spend tomorrow’s income today. Adjustments to meet these expenses are made by drawing on the future income. The core problem, thus, is the need for a lump sum today, which can only be repaid from future incomes in small instalments. There are three elements to this borrowing decision.
The first is the risk to future income. When a salaried household borrows to buy a new television unit, it relies on its ability to repay the loan from a steady future income. The same borrowing by an individual with a temporary income will be at a higher risk, due to uncertainty in his/her future income. The onus of ascertaining the risk to future income, and therefore, the repaying capability of a borrower is on the lender.
However, recent experience shows that lenders have become more adventurous and callous about growing their loan book, and seem more than willing to offer risky loans. This phenomenon is being driven by several factors — ambitious growth rates, poor incentive mechanisms and faulty financial engineering. Therefore, a borrower is offered more, not less, loan, sowing seeds of a debt trap. Borrowers systematically underestimate their own income risks, and tend to be somewhat audacious in picking up higher than serviceable loans. It calls for tremendous grit to refuse a loan that one cannot service from future income.
The second is the nature of the expense. If the expense arises out of an unforeseen event, the household should consider insurance as the first option, before taking a loan to fund it. Insurance is a cheaper tool to deal with unexpected expenses arising on medical grounds, theft, fire, damage to property, etc. Many households view insurance as an investment vehicle, rather than protection from unexpected losses and expenses. Smaller premium amounts can help manage larger unexpected expenses more efficiently than loans.
The third aspect is the deployment of the loan. If the loan is to buy an asset — property, shares, business assets, or education — it holds the potential to generate future income that can be used to repay the loan. Such borrowing is called leveraging. It’s crux is the ability to estimate the generation of an adequate income from the asset to repay the loan. Such assessment needs to be done both by the lender and the borrower, and any risk to the asset’s income-generating capability needs to be identified early and acted upon. This facility requires an ecosystem of continuous monitoring of income, ability to reconstruct, sell and recover, or strategically rework the loan. Borrowers and lenders have to work closely to ensure that risks are managed as they emerge. This is why such loans feature large margins, lien on the collateral being offered and rights to the lender to sell and recover.
A debt trap is primarily the result of using borrowings to fund expenses rather than assets. When we swipe credit cards mindlessly for shopping, we are spending, not building assets. We are spending what we are yet to earn, that is, our future income. With an interest, these reckless loans mean spending more than what we earn. We know of rural households which borrow from microfinance institutions with an intention to create an earning asset but spend it on managing regular expenses in a lean period. Many lenders do not monitor the end use of the loan efficiently. The debt trap arises from an inability to build the asset and spending without considering the risks to one’s future income.
The moral is to keep an eye on your ability to borrow, rather than lean on someone else’s willingness to lend.
The writer is managing director, Centre for Investment Education and Learning. Views expressed are her own