- Microloans can help small businesses launch and grow through small-dollar lending.
- Though they're generally considered a great way to build a credit file for your business, very few lenders in the U.S. offer microloans.
- Unlike some business loans, microloans can be used for a wide range of items or needs.
- This article is for entrepreneurs who want to learn about microloans, how to obtain one and the merits of their use.
If you are starting a business and need money to launch, or trying to grow your small business and need money to hire employees or buy new equipment, you've likely considered applying for a loan. If you don't have an extensive credit history, though, many mainstream lending options may not be available to you. However, a lesser-known solution called a microloan can give you a small injection of cash with reasonable interest rates while bolstering your business's local economy.
What is a microloan and how does it work?
In the realm of business lending, there are loads of small business loan options. Each loan type has its own stipulations and payment periods, interest rates, and qualification requirements. Microloans are no different.
A microloan is a small loan ranging from $500 to $50,000 that must be paid back on a short-term basis. Generally provided by nonprofit organizations, these loans make up only a small fraction of business loans in the U.S., with Kabbage estimating that only 400 financial institutions currently offer them to entrepreneurs. These loans tend to have interest rates between 12% and 18%, with the intent of helping small businesses get off the ground and continue growing.
In many instances, the U.S. Small Business Administration provides the funding for microloans to nonprofit organizations to act as an intermediary lender through the SBA microloan program. Though the SBA's loan program does not "review, underwrite, or have the authority to approve or deny a microloan," the government agency does set guidelines for the microloan program, such as the previously mentioned $50,000 maximum amount. Other regulations include a maximum loan term of six years, a stipulation that the funds can't be used to pay off existing debt or purchase real estate, and a requirement for the "microborrower" to attempt to get a loan from a private source prior to applying for a microloan.
Microloans are useful for short bursts of capital that you'll use for things like buying inventory, paying employees and swallowing seasonal costs. They're also a great way to help your business build credit.
Key takeaway: Microloans are funded by the SBA through intermediary lenders for the purpose of giving fledgling businesses a leg up.
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Who should consider obtaining a microloan?
At their foundation, microloans are built to help small businesses get up and running. As such, if you're looking to get a small amount of funding quickly to start a business and don't necessarily have good enough credit to obtain a loan from traditional lenders, a microloan could work for you. Microlenders generally have less restrictive loan requirements, making microloans significantly easier to obtain than traditional options.
Along with helping small businesses get off the ground, many microlenders use their loans to combat existing inequities in the way capital is provided to small businesses in certain parts of the country. While it's pretty difficult for any up-and-comer to obtain a traditional bank loan for a small business, the odds of being turned down for funding are substantially higher for women and people of color trying to get their venture off the ground than for their white male counterparts. The prospects are even worse in predominantly nonwhite, struggling communities.
To that end, microloan lenders, or mission-focused/mission-based lenders, tend to provide these loans to minority- or female-owned businesses, businesses serving disadvantaged communities, or low-income entrepreneurs. That's not to say that businesses owned by white men can't get a microloan, but lenders tend to look at the overall scope of a microloan borrower and their business, with the overarching mission the lender wants to support in mind.
Key takeaway: Microlenders focus on brand-new businesses and certain groups of entrepreneurs.
Do you qualify for a microloan?
Since microloans are often seen by professionals as a type of "starter" loan to help a business build credit before moving on to a traditional loan, entrepreneurs generally find them significantly easier to obtain than normal loans. While the process is faster and less stringent, experts suggest that there are still some things you can do to prepare for the loan application process.
The following items are things you can do now as a new small business owner to improve your chances of being approved for a microloan.
1. Establish a business plan.
As a newly minted entrepreneur, you've likely already created a general business plan for how you will grow from a startup operation to a profitable company. If you previously applied for a business loan from a traditional bank, then you've likely already completed this step. Being able to show prospective lenders your plans and prove how seriously you'll take the business will give some peace of mind to the lending organization. If you haven't created a business plan yet, you need to outline how your company will make money, what goods or services the business will deal in, and how you will attract new customers, among other things. [Read related article: The Do's and Don'ts of Writing a Great Business Plan]
2. Get your credit and financial houses in order.
When you apply for any type of loan, it's important to take a closer look at your monetary situation. The proper calculations of how much you can pay each month give you a baseline for how much you can realistically borrow and how long your repayment period should be. Even though a microlender is generally more relaxed about the money they're providing small businesses, they still need to be paid back. Failure to do so can spell just as much financial trouble as defaulting on a traditional loan. You should also make sure your business and personal credit scores are in good shape. Even though microloans are typically suited for businesses with little to no credit, lenders often look at an applicant's personal credit history to see how that person handles their own money. Find errors and have them corrected, lower your own credit balances if possible, and clean up some other aspects of your credit report and you should be an easier approval for most lenders. [Read related article: 8 Factors That Keep You From Getting a Small Business Loan]
3. Prepare collateral or a loan guarantee.
Microloans are provided to small businesses and entrepreneurs with little to no credit history. Without a reliable record to see how trustworthy a borrower is, most lenders will require some assurance in the form of collateral. Offering some valuable piece of property as collateral can prove to the bank that you're committed to paying the balance back in full. If you default on the loan, you will lose that collateral and your credit score will take a hit.
Key takeaway: Microloans may be easier to obtain than traditional loans, but there are some actions you can take now to make the process easier.
The downsides of microloans
While there are many reasons that microloans are a huge benefit to the small businesses they serve, they also have some limitations that can hamper their overall usefulness. For instance, most microloans' interest rates hover between 12% and 18%. Those rates are lower than most traditional loans' interest rates, but they rank among the highest loan interest rates provided by the SBA.
If you're looking for a loan worth more than $50,000, a microloan may not be the right choice for you. Microloans not covered by the SBA can go up to $100,000, but those are generally provided to larger businesses. Similarly, if you need a repayment term longer than six years, you likely won't be able to obtain a microloan, since they are higher risks for lenders.
Key takeaway: Microloans are faster and easier to obtain than conventional loans, but they could have high rates and low funding ceilings.