Did you know that the poor pay more for credit than the rich do?

Say Ram is a tailor in a small town while Shyam is an IT Project manager at Infosys. And they both want to buy a house to live in. Ram’s income is small but his needs are also small. He wants a house that will cost say only Rs 10 Lakhs. Shyam lives in the city and wants to stay close to work. The cheapest house he can find that meets his needs are Rs 80 Lakhs. If both approached their banks or finance company, Ram would probably get his loan at about 18% interest while Shyam would get it for 10%. So Ram would pay more for credit (in % terms) than does Shyam.

Why does this happen?

Supply and demand. Microeconomics tells us that when there is abundant supply prices tend to be low. And when there is a lot of demand but very less supply, prices tend to be very high.

Ram finds supply of credit very difficult to come by. Institutions see him as a risky borrower because:

1. He is not a salaried employee. And therefore his income may vary from month to month.
2. He does not have proper documents like invoices or tax papers. Even though he has a bank account he mostly deals with cash and therefore not much of banking history either.
3. He does not have a credit score, yet. So it is very difficult to ascertain his credit history like how many loans has he taken to date and how regular he has been with his repayments. Has he defaulted? If you can’t answer these questions, it becomes harder to ascertain the credit worthiness.
4. He doesn’t have assets. So if his regular income were to be hit, he does not have assets with which he can repay.
5. He wants only Rs 10 Lakhs. Large institutions have big overhead costs. To process a loan application costs time and money. And there is a certain fixed cost in processing an application irrespective of the size of the loan. And so large institutions don’t find it worth the effort catering to small borrowers like Ram. Don’t judge them poorly- it’s basic economics. As you become larger, your size just does not allow you to go after smaller customers.

And because there aren’t that many institutions willing to entertain Ram (low supply), Ram pays a higher price (in % terms) for his loan.

Contrast that with Shyam:

1. He is salaried and therefore you can ascertain his income levels.
2. He can provide all kinds of documents for you- Income statements, Bank statements, Tax papers, Rental Agreements. You name it and he has it.
3. He has a credit score and you can see his credit history.
4. He has assets and liquid cash which you gather from his bank statements.
5. He wants Rs 80 Lakhs. In fact the banks ask him if he wishes to purchase a bigger house because that would mean a bigger loan for the same processing costs.

And therefore Shyam is considered a prime customer. There are scores of institutions willing to fund Shyam. And because there is abundant supply, the rates tend to be competitive. And so Shyam pays a lower price (in % terms) for his loan.

And so, the sad truth is that the poor tend to pay more for credit than the rich. This is a fact in almost every country where mainstream banking and financial services haven’t penetrated the deepest parts of the country.

—

A lot of things look “impossible” until somebody does it. For example, It took nearly 40 years for a man to score 200 runs in Men’s One Day cricket. But there have been 11 instances after that in just 13 years.

In affordable housing, the first man to crack it was Sudhin Choksey at Gruh Finance. Choksey showed that not only is it possible to lend to the poor, you can build a good, strong and profitable business around it. But you can’t do this sitting in air conditioned offices in Mumbai. You need to be on the ground empathizing with your customers and you need to think differently to convert adversity into opportunity. (All Davos kind of language, but hopefully I can back it up with facts.)

Now, because the poor mostly deal in cash and lack documentation you cannot use credit bureau scores. Just because they don’t have credit history doesn’t mean they aren’t credit worthy. So Choksey set up offices in the heart of the country. He himself would sit with tailors, barbers and pakode wallahs to understand their life and livelihood.

He built credit underwriting models that didn’t use hard parameters like income, tax etc. Instead he built models that used softer inputs like – how many clothes does the washerman wash, how many customers are there, what kind of cash flows does he have in good months and bad months, what kind of reputation does a washerman have with his clients? In fact, legend has it that Choksey found a washerman who hadn’t lost a shirt in twenty years! Surely, you can’t lose your shirt lending to a reliable man like him! So Choksey built dozens of templates for assessing credit worthiness of borrowers by profession and they could then predict how much a taxi driver driving an own taxi vs a rented taxi would earn. And so, Choksey and Gruh Finance built a fantastic business around lending to the poor. Lack of formal documents, lack of credit history were adversities but they converted into a large business opportunity.

Like I said, once a man or woman breaks a glass barrier like running a 4-minute mile, others follow and raise the bar higher. Sachin Tendulkar scored the first double century in Men’s cricket but Rohit Sharma has done it thrice and his highest being 264! Once upon a time, an entire team didn’t score 264 and yet one man does it all by himself.

The Rohit Sharma of affordable housing finance, in my humble and biased opinion, would be Sushil Agarwal (founder of Aavas Financiers). He has not only scored a double century, he is raising the bar in many, many ways. I’ll talk about just one. (I used to have more friends and then I couldn’t stop talking about Aavas.)

Nick Sleep, a very famous investor and coined the term “scale model shared”. That is, as some businesses scale, they share the benefits of scale back with the customers who help the business scale further which in turn increases benefits for both the businesses and their customers. Costco, for example, as it becomes bigger it can bargain for better prices from it’s vendors; it’s cost of operations would reduce and these are passed onto customers in the form of lower prices. And these customers purchase more at Costco because of the lower prices thereby helping Costco become bigger and become even more efficient leading to even lower prices. No wonder, Charlie Munger can’t stop talking Costco. (I don’t know about his before-after friend count, though.)

When Aavas started it’s life in 2012, it was a BBB+ rated company. A low rating like BBB+ means Aavas could borrow money from banks at high interest rates (12.3%); and since it’s cost was higher, it had to charge customers like Ram about 18% on the loan. But as it has scaled over the years, it has grown stronger. Today’s it’s ratings are AA- and therefore it’s costs have fallen to 6.9%. Aavas has lowered it’s own lending rates to 12.65%. The benefits of scaling have been passed on to people like Ram.

Before Gruh and Aavas, people like Ram were paying exorbitant rates to moneylenders. After Gruh and Aavas, they pay far lesser rates. And now they have credit history with which they can access other loans like a 2 wheeler loan or a higher education loan.

And if you are wondering, Aavas charges a differential of about 5% between it’s cost and price. This differential is needed for Aavas to hire people, add branches, invest in technology, offset loan losses and make profit for it’s investors. It’s a win-win model for the borrower, for Aavas and for the society in general.

This is what was written in the Annual Report of 2020:

At Aavas, we believe that we will keep providing our customers with progressively lower rates of interest for good reasons: as our brand, footprint and market penetration grow, we expect that so will our debt appetite… we expect to leverage our credit rating and borrow at lower rates. These lower rates we expect to pass on to our customers in the form of a lower cost of loans. We believe that by reducing loan costs we will widen our market, enhance our market competitiveness, lower the cost incidence on customers and strengthen our brand.

-Aavas, Annual Report FY 2020

—

Until Mohammad Yunus at Grameen Bank showed that you can lend to the poorest of the poor to help them come out of poverty, we didn’t have the concept of Microfinance. And now we have dozens in India alone. We used to think that the only way to help the poor was to donate them money. No- sometimes, helping them join the financial mainstream, that you and I are a part of, is the biggest help you can do. Once they join the mainstream, their credit costs come down and they build a credit history; they can afford to take home loans and education loans to better their lives.

A while ago I had written about Rang De. What they do is equally amazing! They connect lenders with poor borrowers. These borrowers are cut off from the financial mainstream and yet they need loans for say buying a cow or loans to start a business or loans to expand their business and so on – all to improve their livelihoods. You get a lower rate of interest that what the bank gives you and the farmer gets a lower rate of interest than if he went to the moneylender. You earn karma, he earns a livelihood.

-Cheers!

PS: I am invested in Aavas. However, this is not a buy recommendation of any sort. I have only taken that as one example of how India is trying to bring more and more people into the financial mainstream.