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Although, interest rate charged by microfinance stimulate of lot of ethical debate. Very few studies in microfinance detail the cost components of interest rates paid by the borrowers. Setting the optimal interest rate with a dual goal of financial sustainability and fighting against poverty is a complex task for microfinance lending. In this backdrop, this paper examines the various cost components of interest rate changed by Indian Self-Help Groups (SHGs) that are financed by not-for profit Microfinance Institutions (MFIs). The study uses neo-classical framework for the analysis of interest rate determinants like cost of funds, administrative (operating) cost, opportunity cost, travel costs and some margin to sustain the business. The data have come from a survey of 106 women SHGs in ten villages in the state of Karnataka, India. The study finds that the cost of fund and other costs associated in microfinance significantly influence the rate of interest and the SHGs need to reduce efficiently other costs associated with writing and maintaining the accounts, auditing, and hospitality offered, through innovative cost management methods of lending. As a result, there would be a welfare gain for the borrowers through reduced interest rate on loans.

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