Microfinance loans are set to turn dearer, owing to the increase in the service tax rate. While the increase may not appear significant because of the small-ticket size of the loans, industry players fear it would hit demand, especially in markets outside Andhra Pradesh, which have been relatively immune to the microfinance crisis.

There is a also a worry that it may lead to a backlash from poor borrowers, as micro-lenders are now being criticised for charging high interest rates from them.

It will be very difficult for us to make our clients understand why they would have to pay more even if the increase is only Rs 10. In the current environment, when the industry is being criticised for charging high interest rates to poor borrowers, even a small increase can be catastrophic. We will have to figure out how to deal with this increase in the service tax rate, said a chief executive of a Hyderabad-based microfinance company.
Finance minister Pranab Mukherjee, in his Budget speech, had proposed the service tax rate be increased from 10 per cent to 12 per cent for financial year 2012-13.

In microfinance, service tax is applicable on the loan processing fee, which is typically one per cent of the loan amount. So, if a customer borrows Rs 50,000 from a micro-lender, he would have to pay Rs 500 as processing fee. With the increase in service tax rate, he would now have to pay an additional Rs 60, instead of Rs 50 a rise of Rs 10.

Micro-lending has become a sensitive issue ever since the crisis in Andhra Pradesh broke out (in October, 2010). For our customers, the question would not be how much is the increase, but why the increase. It is likely to affect loan demand, said a senior official of a microfinance company in Uttar Pradesh.

While some microfinance firms are already exploring options to absorb the rise, most said ultimately, poor borrowers would have to bear the burden of the higher tax rate.

We have a tight rope to walk on. On one side, our margin is capped. On the other, there is a ceiling on our lending rates. We have over 250,000 accounts. It is impossible for us to absorb the rise in service tax, as our profitability has already been eroded because of the crisis in the sector, said an official of a microfinance firm in Andhra Pradesh.

According to the Reserve Bank of Indias guidelines on non-banking finance company microfinance institutions, the margin cap for micro-lenders is fixed at 12 per cent. The banking regulator has also said interest on individual loans should not exceed 26 per cent a year and should be calculated on a reducing-balance basis. Processing charges have been capped at one per cent of the gross loan amount. But these are excluded from margin and interest rate caps.