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

Despite the rapid expansion of microfinance services in the past several decades, the low use of formal credit exhibited by poor households, the high dropout rates experienced by many microfinance institutions, and the prevalence of dual credit markets, even in the most saturated markets, suggest that microcredit may fail to meet the needs of many poor households. This paper examines the importance of repayment rigidity in explaining these three phenomena. While repayment terms are one of many components of a credit contract, they may be of paramount importance for poor borrowers who face high levels of risk and limited means to manage it. Flexible repayment terms are a common feature of the informal loans that dominate poor households’ financial lives, and significant evidence suggests they are a valued feature of informal contracts. Examining the importance of flexibility may illuminate the role that microfinance plays in the lives of poor households and improve understanding of how it can be used most effectively as a poverty alleviation tool. *I am grateful to Miguel Arango for passing on the MIDAS Colombia data, and to Juan Trejo and Ana Cambron of INEGI for help with the ENAMIN data.