Flexibility Matters: Do More Rigid Loan Contracts Reduce Demand for Microfinance?

This paper highlights the importance of repayment flexibility in loans for the poor. It examines the role of repayment rigidity in explaining low usage of formal credit by poor households, high dropout rates among MFI clients and prevalence of dual credit markets.

The paper states that while repayment flexibility is not usual in standard bank contracts, it is a common feature of informal loans taken by poor households. It discusses:

• Differences in loan terms for microfinance and informal loans;
• Data on supply of formal financial credit and phenomena regarding formal credit usage;
• Relationship of contingent repayment with demand for and use of microfinance;
• Alternative explanations for credit behaviour of poor households, such as supply and demand constraints and lack of savings instruments and insurance;
• Viability of flexible repayment in formal contracts;
• Proposal for an experiment to assess the impact of loan flexibility on use of credit.

The paper suggests that provision of a contingent repayment option for microfinance loans is likely to result in changes in use of credit among poor households with income variability.