The morning routine in Palivelupa village, 100 miles north-east of Hyderabad in central India, has been established for years. Once the buffalo are taken to the fields, the tea made and the children sent to school, the women meet under the big neem tree and wait for the debt collectors.

Until recently, Rama Peadda Boiana, a 29-year-old farmer's wife, labourer and mother of three, was in charge. "She was hardworking and clever," Boiana's sister-in-law, Taj Mani, told the Guardian. "That is why she ran the group."

And that could be why she took her own life. Just after the new year, Boiana drank pesticide in the fields outside Palivelupa. She survived for four days in hospital.There were many reasons for her suicide, but the sums she and other local women owed to half a dozen microfinance firms played a big part. Some say Boiana felt responsible for the trouble the villagers were in. Others allege she used others' repayments to pay off her own debts. "We are hardworking people. That's all," said Boiana's husband, Chera Lu, 36.

The story of Boiana and of Palivelupa is that of a good idea gone drastically wrong, devastating the lives of millions of desperately poor people, threatening a banking crisis and revealing the dark side of India's economic growth. Pioneered in Bangladesh in the late 1970s, microfinance involves granting small loans that no conventional bank would give to the very poor, allowing them to launch small-scale economic ventures. Around 30 million households in India have received £4bn in such loans over the past 15 years.

In recent months, however, the industry has been thrown into crisis as it has become clear that a significant number of borrowers – between a tenth and a third, depending on the estimate – cannot afford to repay their loans.

At the heart of this financial and social disaster is the central state of Andhra Pradesh, where the past five years have seen the aggressive selling of loans to often illiterate villagers, followed by equally aggressive debt collection.

"I have nothing, less than nothing left," said Victoria Bandari, who lives in a one-room mud and brick home in Palivelupa. "All I have is debt, which I will pay for the rest of my life."

Addicted to debt

Bandari's story is typical. The 38-year-old took her first loan in the late 1990s from a government-run agency. She spent the 10,000 rupees (£140) on her house. The loan was partly repaid, but when her son was badly injured in a road accident in 2002 Bandari took another loan for a similar sum, this time from a commercial lender.

Within months, the same firm had sold her a supplementary loan. With interest repayments and upfront charges reaching 40% to 50%, Bandari, whose husband works as a labourer for a pound a day, was trapped. Offered further loans as new firms joined a financial feeding frenzy, she had taken on debt of £800 by the end of the decade.

"After the fourth loan they are addicted," said Vijay Mahajan, founder of a major microfinance lender (MFI) and spokesman for the industry in India.

With her creditors pressing morning and evening, and taking her daughters' wedding jewellery as part-payment, Bandari was forced to mortgage her home and her government ration card, issued to "below poverty line" households so they can claim subsidised food. Now someone else in the village is using the card, and the family go hungry.

Lending free-for-all

Stories of aggressive debt collectors are common in villages across Andhra Pradesh. One problem is the number of companies involved in microfinance in the state, and, some analysts say, the business model they use. Until around 2005, most of the industry was run by non-government organisations. To attract more funds, some switched to a new "for profit" model and expanded rapidly. Banks, attracted by returns guaranteed by the combination of repayment rates of up to 98% and compound interest rates of between 25% and 50%, poured in cash. Soon, more than 150 institutions were lending in a chaotic free-for-all.

A bid to impose self-regulation in 2006 failed. Venkat Narayana, professor of economics at Kakatiya University in the Warangal, the centre of the crisis, said: "Many are motivated simply by money. The capital is coming from overseas Indians, the internet boom, corrupt politicians. They are seeking profit among the poorest of the poor."

Narayana said many villagers had spent their loans on consumer items such as mobile phones, motorbikes and TVs. "Even if they do invest, it is often in something that cannot be sustained. The mass media has exposed them to a new dream of material affluence."

Like many villagers, Bandari used much of the cash to pay for the schooling and marriages of her children. "The money just goes. I don't know where," she said.

Mahajan, the industry spokesman, admitted that many microfinance institutions had been "reckless" in their lending and some had charged very high interest rates and paid directors million-dollar salaries. "This kind of behaviour is hard to defend," said Mahajan, whose own company, Basix, has 500,000 customers.

Almost 80% of loans in Andhra Pradesh have been made by three firms. Records of debts owed to one, SKS Microfinance, lie piled on the floor of Boiana's home in Palivelpula among her relatives in mourning.

The flotation of SKS Microfinance on the stock exchange last year generated $350m (£225m). Atul Takle, a spokesman for the company, denied any link to a spate of deaths in the state. "Suicides are a tragic occurrence and a complex situation. There were around 17 of our borrowers who are reported to have committed suicide. However, none of them had any outstanding [loans] so there was no question of coercing them to pay. All of the 17 also had loans from other microfinance institutions," he told the Guardian.

Blow to development

Takle said some "rogue MFIs" could have been overlending, but insisted that SKS Microfinance vetted clients carefully and had brought interest rates down from more than 40% to just over 25%.

The future of the industry is uncertain. In October last year, the government of Andhra Pradesh imposed new restrictions, in effect halting new loans and slashing repayment levels.

"The industry here is dying a slow death now," said Mahajan. "It is really tragic. This is a huge blow to sustainable financing for the poor. It will take a decade before anyone sensible goes back into this field."

Vasant Kumar, the minister who drafted the laws, said it had been imperative to stop "atrocious activities". There is no question of cancellation of loans however, he said.

Since the law was passed, the debt collectors have stopped coming to Palivelpula, but the respite will only be temporary. The morning visits will soon start again.