Dear Economist: Why are poorer borrowers better at repaying loans?

Dear Economist,
I am perplexed by the enormous publicity devoted to the subprime debacle while micro-credit lenders have been showered with praise. Isn’t Countrywide just a micro-credit lender for the US, except that people are borrowing for homes rather than bullocks? And why are borrowers in developing countries so much better at repaying their loans?

Bombay Beauty

Dear Bombay Beauty,

No problem explaining why it is easier to repay a microfinance loan: the loans are a lot smaller. Beyond that, you have a point. Microfinance loans, like subprime loans, target poor clients in underserved communities, and charge high interest rates.

The economist Dean Karlan argues that the difference is largely about spin. We hear about the far-away people whose lives have been transformed by microfinance, and we hear about the subprime defaulters whose lives are in a mess. But Karlan points out that micro-credit borrowers do default, and that subprime default rates are much lower than you would think. And while some subprime borrowers were duped by complicated loan terms, financial literacy is even worse in developing countries.

Karlan also argues that micro-credit “group liability” schemes are overrated. In such a scheme, friends and neighbours have to make up the shortfall if someone can’t pay. But an experiment carried out by Karlan showed that such schemes put off borrowers without increasing repayment rates.

None of this is to condemn microfinance. Rather, it is worth remembering that poor people can benefit from access to credit, even if the credit is expensive – and even if they live in the US.

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