Why do more than 50% of India’s urban poor still rely on informal credit systems? Find out

Poor urban households’ dependence on informal credit systems remains a key challenge on the path to financial inclusion. Despite advances in formal banking services, more than 50% of India’s urban poor households remain dependent on informal sources of credit, contributing to an unorganized credit market estimated at nearly US$100 billion. This dependency underlines the urgent need to understand the systemic barriers and address the gaps in formal financial services.

Persistent barriers to formal access to credit

Urban poor households often face insurmountable barriers in their attempts to access formal credit. For example, more than 40% of low-income households in India lack essential documentation, such as income proof or identity cards, which are a prerequisite for formal loans. Furthermore, because nearly 63 million Indians have thin or non-existent credit files, financial institutions struggle to assess their creditworthiness, leading to high rejection rates.

Even if access is theoretically possible, the complexity of banking processes – from lengthy application processes to rigid repayment structures – alienates many potential borrowers. A World Bank study further shows that poor urban communities often live in areas where no bank branches or digital financial services are available, further exacerbating their exclusion. In contrast, informal credit systems function within neighborhoods and fill this accessibility gap 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. For example, lenders do not require documentation and often disburse loans within hours. This immediacy is critical for households facing emergency medical costs or other financial crises. Borrowers also appreciate the flexibility that informal lenders offer, such as customized repayment schedules tailored to irregular income flows – a feature that formal institutions rarely take into account.

Trust plays a crucial role in the survival of informal credit. Borrowers often have a personal relationship with their lenders, which reduces the fear of rejection or judgment. However, this reliance comes at a high cost: informal loans often come with annual interest rates ranging from 36% to 120%, pushing households into cycles of debt. Despite these disadvantages, awareness of affordable formal credit options remains low. A report by Micro Save shows that only 27% of the urban poor are aware of government-backed schemes or low-interest microloans.

The impact of informal credit dependence

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

Perhaps most importantly, dependence on informal credit prevents households from building a formal credit history. 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

To address this problem, systemic reforms and targeted interventions are needed. Increasing financial literacy is a fundamental step. Initiatives such as the RBI’s Financial Literacy Week have shown promise, but scaling these efforts through community-based workshops and digital platforms can significantly increase awareness of formal credit options.

Simplifying lending processes is just as essential. For example, pre-approved microloan programs that limit approval times to minutes can make formal credit more attractive to low-income households. Institutions like Credila have pioneered innovations in education lending, financing higher education for over 178,000 Indian students. This remarkable achievement demonstrates the feasibility and transformative impact of customized financial products in meeting specific needs.

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

In addition, artificial intelligence (AI) is playing an increasingly important role in addressing the limitations of traditional credit underwriting. AI-powered platforms can analyze alternative data sources, such as cell phone usage, utility payments and transaction history, to create nuanced credit profiles for borrowers with little to no formal credit history. For example, platforms using AI-powered 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, reduce delays and offer customized credit products that suit the borrower’s financial circumstances.

Policy support is critical to sustain these efforts. Government schemes like the Pradhan Mantri Mudra Yojana, which has been disbursed ₹18 lakh crore in loans should come with 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 change perceptions and encourage adoption of formal lending 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 this underserved segment with a viable path to financial inclusion.

By addressing these challenges and promoting collaboration between policymakers, financial institutions and community organizations, we can reduce the urban poor’s dependence on informal credit. Only then can we pave the way for fair financial inclusion to which every household makes a positive contribution.

Joydip Gupta, Head of APAC, Scienaptic