Why Borrow?

At the most basic level, credit provides the opportunity to move consumption or investment to the present. Borrowing can help smooth periodic ups and downs caused by the irregular income flows common in poor families. Borrowing also allows families to acquire a “usefully large” sum of money to be used for a big purchase. The alternative is waiting to accumulate such a sum through savings—a challenge that many households may find difficult or impossible.  As a result, microcredit loans—even microloans targeted to entrepreneurs—are used in a variety of ways.

• http://www.ebrd.com/downloads/research/economics/workingpapers/wp0136.pdf
• http://financialaccess.org/sites/default/files/publications/pop-briefing-note-7-grameen-ii-and-portfolios-of-the-poor.pdf
• http://karlan.yale.edu/p/JDE-ListRandomization.pdf

A big view can be seen through the Global Findex study, conducted by Gallup, which shows the uses of loans from all lending sources (not just microfinance institutions) across all income groups (not just low-income). The survey shows that 16% of households in low-income countries and almost 15% of households in lower-middle-income countries had borrowed to cover the costs of health-related emergencies. We also see that a significant percentage of households in both country groups had borrowed to offset the costs of school fees, housing construction, funerals or weddings, or to purchase housing. Respondents were allowed to report more than one reason for borrowing, so many households may have taken loans out to cover more than one type of expense. (Borrowing for business was not an option in this survey.)

A Behavioral Twist

There’s another reason to borrow, and it has a behavioral twist. Behavioral economics gives psychological reasons for why it can be hard to save, and that naturally makes borrowing more of a necessity when you need money. But there’s also a subtler (though more direct) connection: the activities around saving and borrowing look pretty similar in important ways. Saving usually involves making small, periodic deposits into an account in order to have a big sum in the future. Borrowing through microcredit also usually requires making small, periodic transfers and getting a stream of big sums in the future. Borrowing, however, has a useful commitment device attached; it is harder to skip periodic payments to a lender (who has the power to enforce a contract) than to skip deposits to yourself. It is also often easier for a poor household to obtain a loan than a secure, regulated, and convenient savings account. One implication is that if you have already managed to put away some savings, you have a good reason to want to protect them, maybe even by borrowing. Another implication is that if you don’t have great ways to save, microcredit borrowing can be a substitute accumulation device, as suggested by evidence from India. In the end, saving and borrowing are often complements, not substitutes. Being able to borrow can help you hold on to your hard-earned savings. When important needs arise, you may use your savings plus borrow. Those who argue that credit is more important than saving – or vice versa – are missing the point.

Too Much Debt

Of course, the use of credit is not always so rosy. Some people continue to borrow because they are caught in “debt traps.” It is not hard to find yourself in a debt trap; you borrow to cover the cost of an urgent need and use the income you earn in the following weeks or months to pay back the loan. But once you have used your income to pay it back, you do not have enough left over to cover your current expenses and you must borrow again to stay afloat. Some households may be able to escape these traps, but many others are stuck in them indefinitely or until they must default.

The Value of Options

So why not borrow? Take-up rates of microcredit in poor communities are always well under 100 percent, and usually well under 50 percent. Some families choose to ration their use of credit out of fear of over-indebtedness. Other households may not borrow because the credit products available are expensive or do not suit their particular borrowing needs. Even as attention turns to other financial products, there’s further in credit product design.