Why over 50% of urban poor in India still rely on informal credit systems? Find out | Mint

The reliance of urban poor households on informal credit systems remains a significant challenge in the journey toward financial inclusion. Despite advancements in formal banking services, over 50% of urban poor households in India continue to rely on informal credit sources, contributing to an unorganised lending market estimated at nearly $100 billion. This dependence underscores the pressing need to understand the systemic barriers and address the gaps in formal financial services.

Persistent barriers to formal credit access

Urban poor households often face insurmountable hurdles when attempting to access formal credit. For example, over 40% of low-income households in India lack essential documentation such as income proof or identity cards, which are prerequisites for formal loans. Additionally, with nearly 63 million Indians having thin or non-existent credit files, financial institutions struggle to assess their creditworthiness, leading to high rejection rates.

Even when access is theoretically possible, the complexity of banking processes—from lengthy application procedures to rigid repayment structures—alienates many potential borrowers. A World Bank study further highlights that urban poor communities often live in areas underserved by bank branches or digital financial services, compounding their exclusion. In contrast, informal credit systems operate within neighbourhoods, filling this accessibility void by offering quick, flexible solutions.

Why informal credit persists

Informal lenders have become a lifeline for many urban poor households due to their unparalleled ease of access. Moneylenders, for instance, do not require documentation and often disburse loans within hours. This immediacy is critical for households facing urgent medical expenses or other financial crises. Borrowers also appreciate the flexibility informal lenders offer, such as customised repayment schedules aligned with irregular income flows—a feature formal institutions rarely accommodate.

Trust plays a pivotal role in the persistence of informal credit. Borrowers often have personal relationships with their lenders, reducing the fear of rejection or judgment. However, this trust comes at a steep cost: informal loans frequently carry annual interest rates ranging from 36% to 120%, trapping households in debt cycles. Despite these drawbacks, awareness of affordable formal credit options remains low. A report by Micro save found that only 27% of the urban poor are aware of government-backed schemes or low-interest micro loans.

The impact of informal credit dependency

While informal credit provides immediate financial relief, its long-term consequences are dire. High-interest rates drain household incomes, leaving little room for savings or investments. A study in urban slums revealed that 60% of borrowers struggled with repayments, often resorting to additional borrowing to meet obligations, perpetuating a cycle of debt. Borrowers also face exploitation, including coercive repayment practices and the seizure of personal assets, further destabilising their financial well-being.

Perhaps most critically, reliance on informal credit prevents households from building formal credit histories. Without a credit score, they remain excluded from affordable financial products that could improve their economic prospects, perpetuating a cycle of poverty and financial insecurity.

Breaking the cycle

Tackling this issue requires systemic reforms and targeted interventions. Enhancing financial literacy is a foundational step. Initiatives like the RBI’s Financial Literacy Week have shown promise, but scaling these efforts through community-based workshops and digital platforms can significantly improve awareness of formal credit options.

Simplifying lending processes is equally essential. For instance, pre-approved micro loan programs that reduce approval times to minutes can make formal credit more appealing to low-income households. Institutions like Credila have pioneered innovations in education loans, funding over 178,000 Indian students pursuing higher education. This remarkable achievement demonstrates the feasibility and transformative impact of tailored financial products in addressing specific needs.

Expanding the reach of micro finance institutions and credit cooperatives offers another viable solution. For example, organisations like CreditAccess Grameen have demonstrated the potential of targeted micro finance, with their loan portfolio growing by 27% year-on-year. Such growth underscores the transformative impact that well-designed micro finance initiatives can have on empowering underserved communities. Similarly, digital lending platforms are leveraging alternative data—such as utility payment histories—to include individuals without traditional credit scores.

Moreover, artificial intelligence (AI) is playing an increasingly significant role in addressing the limitations of traditional credit underwriting. AI-powered platforms can analyze alternative data sources, such as mobile phone usage, utility payments, and transaction histories, to create nuanced credit profiles for borrowers with little to no formal credit history. For instance, platforms using AI-driven underwriting have shown a 30% improvement in credit access for low-income borrowers while maintaining portfolio quality. These systems also enable real-time decision-making, reducing delays and offering tailored credit products that align with the borrower’s financial circumstances.

Policy support is crucial to sustain these efforts. Government schemes like the Pradhan Mantri Mudra Yojana, which has disbursed over ₹18 lakh crore in loans, must be accompanied by incentives for financial institutions to serve high-risk, low-income borrowers. Building trust between formal financial systems and the urban poor is equally important. Consistent community engagement and transparent practices can help shift perceptions and encourage adoption of formal credit solutions.

Another way to break this cycle is through the adoption of alternative data frameworks, such as Account Aggregator (AA), by both borrowers and lenders. Leveraging AA systems can bridge the gap for those excluded from traditional credit assessments, providing a viable pathway toward financial inclusion for this underserved segment.

By addressing these challenges and fostering collaboration between policymakers, financial institutions, and community organisations, we can reduce the urban poor’s dependence on informal credit. Only then can we pave the way for equitable financial inclusion that uplifts every household.

Joydip Gupta, Head of APAC, Scienaptic