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Microfinance: What Is It, and Why Does It Matter?

Matt D'Angelo
Matt D'Angelo

Microfinancing is a type of lending that can have a significant impact, especially in the developing world.

Qualifying for a business loan is no easy feat. You have to provide seemingly endless documentation, and even healthy, well-functioning businesses can be denied. Acquiring financing in the modern business landscape is especially difficult if you're considered a high-risk borrower. 

Businesses in extremely poor areas or the developing world are often the most affected by this challenge. It can be difficult for people from these areas to start their own businesses, and they may not have access to traditional banking options in their area or even country. 

That's where microfinancing comes in. Microfinancing is defined as a provision of financial services that's available to low-income people. This type of loan helps aspiring entrepreneurs generate income, build assets, manage risks and meet their household needs. 

"The end goal of microfinance is to have its users outgrow these smaller loans and become ready for a traditional bank loan," said Yuliya Tarasava, co-founder and COO of CNote.

History of microfinance

According to MicroWorld, microfinance has been around for centuries in some form or another, and even longer in Asia as a form of informal lending. What we know as microfinance today was born in Bangladesh sometime in the '70s. 

"In the midst of a famine, Dr. Muhammad Yunus, professor of economics at the University of Chittagong, was becoming disillusioned with the abstract theories of economics that failed to explain why so many poor people were starving in Bangladesh," MicroWorld states. Thus, the $27 loan was born as a practical solution. 

In the Bangladeshi village of Jobra, Yunus discovered that a group of 42 women made bamboo stools but did not have the money to purchase the raw materials for them. As a result, the women fell into a cycle of debt to the community's traders. The traders would lend the women the funds they needed with one stipulation: They would sell the stools at a price only slightly higher than the cost of the raw materials. Yunus lent them $27 of his own money, which covered the borrowing needs of the 42 women combined. By selling their stools at a fair price, they were able to climb out of their debt cycle. 

Microfinancing evolved with Joseph Blatchford, a former head of the Peace Corps and a UC Berkeley law student. Blatchford founded the nonprofit Accion as a volunteer project in 1961. In 1973, his organization began offering small loans to entrepreneurs in Brazil to see if a one-time influx of money could help lift them out of poverty. The operation was a success: 885 loans helped create or stabilize 1,386 new jobs. Accion expanded the model to 14 other Latin American countries over the next decade.

Where can I get microfinancing?

This specialized financing is available through small nonprofit organizations as well as larger banks. Popular microfinancing institutions include Accion, GE Consumer Finance, Citi Inclusive Finance, Kiva and BRAC. Also be sure to check out our reviews of the best alternative small business loan resources. 

When you speak to lenders and are granted a small loan, you can also expect assistance in setting up and maintaining a savings account. A good lender will equip you with the tools to pay back the loan. 

"Although microfinance is often discussed in the international context, there are several lending institutions in America that make these types of loans to increase economic opportunity in local communities," Tarasava said. "Many CDFIs (community development financial institutions) offer microloans to the communities they serve … [with] favorable small business terms … and they provide consulting resources and financial education to help increase the likelihood of borrower success." 

 

Editor's note: Looking for information on business loans? Fill in the questionnaire below, and you will be contacted by alternative lenders ready to discuss your loan needs. 

How to get approved for microfinancing

While approval is, of course, up to the lender, there are some things you can do to increase your chances of getting approved. 

1. Write a business plan.

Lenders want to see that you take your business seriously and have a plan, because they want to work with people who are likely to succeed. Every successful business plan includes a company overview, introduction, mission statement, market and industry analysis, marketing plan, and operations plan. [Read related article: 5 Tips to Write a Great Business Plan]

2. Have decent credit.

Even though you currently don't have a lot of money, good credit makes an excellent impression. Carefully review your report, ensuring that it does not have any false information; if it does, send out disputes accordingly. Did you know you are entitled to one free report each year?

3. Seal the deal with a personal guarantee or collateral.

Your personal guarantee is your legal promise to repay the loan. Collateral, such as your house, is something lenders can use against you if you don't repay it. If you're confident your business will succeed, offering these two things makes sense so you can get a loan.

4. Invest some of your own money.

A business owner who puts their own personal investment into their company along with a microloan shows that they are serious and will make sure their business succeeds.

Why are interest rates higher in microfinance loans than in traditional banking?

Microfinancing is designed for low-income borrowers who are a higher risk to banks. As standard lending logic follows, the higher the risk of the investment, the higher the interest rate and compensation for the lender. Banks and other lenders want to be compensated for the potential of not receiving their money back. High interest rates, which can be suffocating for small businesses, ensure the lender receives some return on investment. 

That being said, microfinancing rates can vary wildly compared to traditional bank interest rates. According to The Wall Street Journal, microfinancing rates can exceed 30%. While the risk-reward ratio of lending to a low-income individual is part of the deal, microfinancing scenarios are usually more expensive for the bank, especially in foreign investment cases. For example, the loan officers often have to travel to businesses in low-income areas, rather than a potential borrower visiting their local bank branch to inquire about loans. 

While these interest rates are considered astronomically high compared to traditional bank loans, the lender will still review the borrower's finances to ensure repayment is within the borrower's means.

What is the difference between microfinance and microcredit?

While they may sound similar, there is a key difference between microfinance and microcredit: Microfinance encompasses a broad offering of financial services for low-income communities, while microcredit refers specifically to small loans for people below the poverty line. In other words, microcredit is a subset of microfinance. 

Microcredit is loans offered to unemployed individuals who lack collateral and credit history. This capital can give new, low-income entrepreneurs the injection needed to get started. The goal of microcredit is to empower poor communities across the developing world to start their own businesses and enter the economy. 

Of course, microfinance embodies all these things too. It also includes a wide range of other financial services, like checking and savings accounts, microinsurance, and business education. 

For more information on business financing, read our guide on how to choose the right small business loan

Rissa Ann contributed to the reporting and writing in this article.

Image Credit: Jacob Ammentorp Lund / Getty Images
Matt D'Angelo
Matt D'Angelo,
Business News Daily Writer
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I'm a staff writer for Business.com and Business News Daily. I cover various small business topics, including technology, financing and marketing.