+ 12/31/2009 
DIG will continue to further housing finance for the poor despite -  
+ 5/8/2009 
CapStone makes 1,000th Loan -  
+ 4/1/2009 
DIG presents Market Assessment and Strategic Plan to Angola Partner -  

Product Design: HMF
Note: The material in this section is adapted from Chapter five, Elements of Product Design for Housing Microfinance, in Housing Microfinance: A Guide to Practice  by Franck Daphnis.  Should any part of the section below be referenced, please specify that it is adapted from Mr. Daphnis' work.

You have gone through the process of making sure that you can legally and effectively offer microfinance capital for housing.  You have also made sure that there are enough potential clients within your income target that need housing improvement and are capable of paying back a modest loan.  Basically, your environmental assessment and market research suggests that you can go to the next step: designing an actual housing microfinance product. 

As opposed to mortgages, housing microfinance products are almost always used for small, cost-effective, progressive home improvements.  These can range from material replacements to utility service linkage to room additions and sometimes to land acquisition, but rarely include the purchase of a new or used full home.  Potential clients for housing microfinance are usually self-employed or very low-income salaried employees who most often live in self-built homes.  In rural areas, clients could have full title to their lands while in urban areas, client homes are often in informal settlements that may or not carry formal title and proof of ownership. 

In either case, the microfinance credit can be used for any number of housing-related needs.  In fact, many clients of microenterprise loans often put the capital to use for housing needs before housing-specific microfinance products came on the market.  Therefore, most housing microfinance products to date follow the same design that was developed for microfinance products. That is, they focus entirely on the client’s ability to consume capital and the institution’s ability to provide it.  Some products also look at what the capital will be used for, or the house itself, in order to tailor the product even more appropriately.  Such perspectives can contribute to the product’s final design.

Designing a Loan for the Client

What can a client afford?
A client’s current income is the most important element for determining capacity to repay a loan.  It is also the most difficult, since potential clients are of a lower-income category and often do not have fixed regular incomes.  If the client does have a regular salary, then eligibility can be calculated straightforwardly.  If he/she does not (which is the case for self-employed clients), then one must take into account all of the business transactions (purchases and sales), revenues, and costs over a longer amount of time that can be averaged into a monthly income estimate.

Once an income level is determined and can be verified with additional documentation, site visits, and interviews, the client should fit a basic eligibility profile.  The institution has a variety of ways to determine this.  One way is to assume that a percentage of a client’s monthly income can be taken out to pay back a housing loan.  Housing is one of, if not the biggest expenses a family has, usually comprising between 25% and 35% for most clients.  Thus, loan providers assume that a client can pay up to 25%-35% of his/her monthly income every month to pay back a loan (including the loan value they took out plus the interest and any fees). 

Other institutions assume that the most any house can afford is whatever they have left over on average every month (that is, total income minus total expenses).  This method could be more conservative if the client has or will have a lot of additional expenses (or inflation might increase the cost of those expenses), but constrains the eligibility of many clients.

When and how can they pay?
Regardless of how much or how little a client makes or is willing to pay for a housing loan, there are certain other constraints based on the circumstances.  These affect the method of delivering the loan (group versus individual loans), its repayment period, the schedule of repayments, and the method of repayment, along with the loan size.  Typical ranges for all of these are provided at the end of this design guide.

There are certain generally accepted parameters that set this out.  For example, most housing microfinance loans are given to individuals or individual households rather than through group lending, simply because the repayment record is worse for the latter.  Like traditional microfinance loans, however, clients are approved through the existing loan documentation and origination methods, and they pay on a regular basis (usually monthly) through the existing payment mechanisms.

The biggest difference between housing and non-housing microfinance loans is the size and term.  Most income-eligible clients have to take on larger loan sizes than traditional microenterprise loans where repayment is longer, since the home improvement process typically costs more and lasts longer.  Generally, home improvement microfinance loans have maximum loan sizes from US$300 to $2,500 and are repaid over anywhere from three months to two years (though some can go up to five years).  Though this depends largely on the individual client’s capacity, the institution’s risk management, and the local cost of home improvements, the general assumption is that housing microfinance loan sizes and terms will be larger and longer than traditional microfinance, but much less than mortgages.  Depending on the clients to which the housing microfinance loan will be marketed (for example, only past clients with good records), the institution might view these loans as more or less risky.  The terms would match that risk.

Ultimately, microfinance institutions must understand their clients well to be able to set these terms and  feel comfortable with providing them.
Designing a Loan for the Institution
What can the institution afford?
You, as the institution providing capital, have several constraints that define the final loan product’s design.  These include:
  • How much it costs to run the institutions and manage the loans

Your administrative expenses include the salaries of your staff, of the equipment and services, and other institutional costs that will be needed to run the housing loan.  For microfinance institutions, this is usually high because of the level of client interaction and verification.  Make sure to annualize the cost and then express it as a percentage of the outstanding loan portfolio.

  • How much you might lose if some clients don’t pay

Your loan losses, or more appropriately, what you expect your losses to be, play a critical role in shaping how much you charge all your clients.  Basically, you want to make up for your expected losses.  Previous experiences with these kinds of loans suggest that 3% of clients will be at risk of defaulting.  So, that number is a good start.

  • How much other institutions charge you to borrow money that you will lend to your clients (cost of funds)

You have to get money from other sources in order to give it out in loans to your clients.  Many microfinance institutions can utilize subsidies and donations, meaning that the cost of funds is minimal or zero for them.  This is increasingly rare as institutions are becoming more financially independent and sustainable.  They can now obtain good rates from commercial sources, have increasing deposits from their clients (when they’re allowed to take deposits), and have many private investors available.

  • How much you expect or need in profit to either capitalize more, distribute to investors or shareholders, or other needs
  • Whether you have income from other sources or investments that could affect how you offer your housing loan

All of these factors will determine how much you charge for the loan in the form of interest rate and any other fees.  A rule of thumb established by Richard Rosenberg (CGAP 1996) is as follows:

Rate  = (Admin Expenses + Loan Losses + Cost of Funds + Capitalization Rate - Investment Income)
 (1- Loan Loss)

On average, the rates for these loans range anywhere from 15% (among those with more stringent requirements) to 40% (to those with stand-alone home finance loans), which can be more or less than an institution’s microenterprise loans depending on the number and burden of additional requirements that the institution puts on the housing loan.  Ultimately, the institution will want to set rates at at a level where clients can afford to repay, but where the institution will still make money off the entire outstanding loan portfolio.
Therefore, expected loan losses figure prominently in how an institution determines what to charge. 

What can reassure the institution?
In response, many institutions will try to reduce the risk of non-repayment in various ways.  Often, they will offer the loans only to certain clients such as those with good track records evident from other loans or savings programs.  Often, this link to other loans will be a requirement for loan eligibility, especially for poorer clients who need even longer periods of time to repay loans that cover a housing imrovement.   For example, some microfinance institutions offer housing microfinance loans as rewards for good repayment on enterprise loans. 

Many institutions will not give a client a loan if the total amount of debt with the new loan (if they know of other loans) exceeds a certain total percentage of the income (for example, 40%-50%) for fear that the client would not be able to make good on all of the outstanding loans.
Eligibility based on income or financial history, though, is still only part of the clients’ effect on loan design.  Most institutions also want some assurance that the client will repay the loan that serves as an incentive to repay.  Since the institution cannot take over the house if the client does not  pay for a mortgage, equipment or other physical assets (nor would it want to), other assurances have to reduce the risk from the client. 

Some institutions might require a minimal deposit or down payment.  Others might require a “refundable deposit” in the form of a preexisting savings account.  Still others might require co-signers with proven good credit histories.  Any combination of these could work depending on the clients in the local market.

Even though these loans are usually not equal to the value of the house (thereby requiring a mortgage), some institutions will require proof of land ownership or house registration before giving the loan as collateral.  Oftentimes, this is simply because financial laws in the country require proof of land tenure for a housing-specific credit. Land tenure is normally difficult to prove though, and other less strict methods of proving land security (that is, that the client occupies the land at the time of application and will likely occupy it throughout the repayment period based on local practices) are used instead.  These include unofficial written documentation such as land agreements, tax or utility payments, and other proof of occupation. 

A final reassurance for the institution can come in the form of educating or counseling the client before and during the loan disbursement.  Since many clients will have every intention of repaying their loans, but are simply not familiar with the processes, such counseling can help increase repayment and decrease short-term arrears and long-term defaulting.  Often, this counseling focuses only on financial literacy.  When it comes to housing loans, however, additional assistance programs have also been tried.
Designing a Loan for the House

For most institutions, the above parameters are enough to design a housing microfinance product.  Yet, often they need to assure that the client will use the loan well (in order to assure that the client will continue to repay), or use the loan for housing exclusively (if tied to a subsidy or a public service).  Many NGO financial institutions are also concerned with the basic standard of living for their clients.

Thus, further requirements focusing on the cost and quality of the home improvement itself are often added.  Sometimes, this involves general verification of the cost and schedule of the improvement to make sure that it matches to the size and terms of the loan.  A more involved requirement would involve providing the client with construction guidance to improve the likelihood of that match.  Some institutions will even perform regular site visits to verify that clients are adhering the scope of work, and will provide additional technical assistance.  Perhaps the most complicated scenario for construction assistance, from the institution's point of view, involves making a deal with material vendors or actual builders to provide the exact improvement that will match the specific loan.  These last, more extreme scenarios mirror the alternative housing credits that might be offered by the vendors or builders themselves.

Again, not every institution provides this assistance or requires it and there are varying examples of how this is done and whether it helps increase repayment performance.  You should always keep in mind that any counseling or additional technical requirements (whether it’s general financial literacy or construction assistance) will add to your administrative expenses. Therefore, the expected gain from reduced losses needs to outweigh these costs.
Designing the Loan

All of the above factors are summarized here, and the final decisions that need to be made are summarized in the checklist following.

Housing Microfinance Factors
  • Factor
  • Client
  • Need
  • Capacity
  • Eligibility
  • General Product Terms
  • Origination Methodology
  • Servicing Methodology
  • Requirements
  • Institutional Need
  • Institutional Constraints
Housing Microfinance Decisions
  • Decision
  • Capacity
  • Loan Size
  • Loan Term
  • Interest Rate
  • Eligibility
  • Requirements
  • Assistance
For any product to be successful, some preliminary checking through affordability tests has to be performed before launching and offering the first loans.  These tests can be broken out into the following steps:
Step 1. Determining the range of loan sizes (based on different home improvements)
Step 2. Determining the repayment periods for different loan sizes
Step 3. Determining the interest rate.
Step 4. Determining the monthly payments
Step 5. Matching the monthly payments with the capacity to pay.
Step 6. Determining the market and revenues for feasibility
Step 7. Adding/Subtracting requirements
Step 8. Changing the terms and Repeating
Step 9. Prepare for Launch