Microcredit or Micro loan is a general term to describe loan services to low income individuals who cannot gain access to loans from traditional banking services.
Micro loan is given on the principle that low income individuals are capable of getting themselves out of poverty if given access to finance from these loans.
The nature of micro loan meant that interest rates would have to be high to return the cost of the loan. This is so as the interest rate charged for a micro loan would have to cover for the cost of the money lent, the cost of loan defaults and the transaction cost of the micro loan. While cost of the money lent and loan defaults are proportional to the amount lent, transaction costs of a micro loan is not.
Take a personal loan of $1,000 against a micro loan of $300 and you will find that the transaction costs of both loans to be not much different. Be it a personal loan or micro loan, both require about the same amount of staff time to appraise the loan, processing the loan disbursement and repayments. If the interest is 10% the default charge is 1% for both the personal loan and micro loan, and the transaction cost is $50 per loan, then the total interest charged for the personal loan would be $100 + $10 + $50 = $160 or 16%. For the micro loan, the total interest charged would be $30 + $3 + $50 = $83or 27.6%. The interest charged for a micro loan may look high, but in reality it simply reflect the basic fact that when loan amounts get very small, transaction costs will be higher proportional to the loan otherwise business will be out of pockets lending money through micro loan.