Question

Analyse the negative impacts of informal sources of loans.

Hint:

Start from the fact that no organisation supervises informal lenders, then bring out the high interest rate, the loss of income in repayment, the debt trap and the discouragement of new enterprise.

Answer 1

Concept:

• Informal sources of credit include moneylenders, traders, employers, relatives and friends, and there is no organisation that supervises their lending.
• Because nobody controls them, they can set their own terms, and those terms usually work against the borrower.

Step 1: The rate of interest is very high.
Informal lenders charge a much higher interest than banks and cooperatives. There is no one to stop them, since the Reserve Bank of India supervises only the formal sources.

Step 2: A high cost of borrowing eats up the earnings of the borrower.
When the interest is high, a larger part of the earnings of the borrower is used to repay the loan. Less is left for the household, so the borrower has less income to spend on food, health and education.

Step 3: It discourages people from starting an enterprise.
Someone who wishes to start a small business may decide against it, because the cost of borrowing is so high that the business would not cover it. Useful work that could have been done is therefore never begun.

Step 4: It can push the borrower into a debt trap.
In some cases the high interest for borrowing means that the amount to be repaid is greater than the income of the borrower. This is called a debt trap, a situation from which recovery is very painful.
A farmer who borrows for a crop that then fails may have to sell part of the land to repay, ending worse off than before the loan.

Step 5: Lenders may use unfair means of recovery.
Since there is no supervision, informal lenders can employ harsh and unfair methods to get their money back. The borrower has little protection and often no written record of the terms agreed.

Final Answer: Informal loans carry very high interest, take away a large share of the earnings of the borrower, discourage new enterprise, can trap a family in debt from which escape is painful, and leave the borrower exposed to unfair recovery methods because no authority supervises these lenders.