Beginner’s Breakdown of Microfinance

I made my first microfinance loan as a college student. I went through Kiva, and with each paycheck, I would send $25 to parts unknown in the hopes that my bit of surplus could make a difference for someone else.

I still lend as regularly as I can, though full financial independence and accompanying responsibility mean that it doesn’t happen each and every paycheck. As the little anthropologist that I was trained to be, it’s always been a social benefit thing for me, but microfinance loans are a real form of investment.

If you do them right, you might not see huge return on your money, but you will see just how far a dollar can go.

Microfinance 101

So just what is microfinance, anyway? On a simple level, microfinance is a source of financial services for business owners and small businesses that lack access to traditional banking and financial services.

Perhaps the most prevalent form of microfinance is microcredit – extending small loans to impoverished borrowers that may lack collateral, steady income, or credit history. Peer-to-peer networks have become a big source of public discourse regarding microfinance in recent years, but it happens on many  levels from government subsidies to traditional financial institutions creating micro lending and micro savings programs and insurance companies working on a micro-level, often as part of a non-profit affiliated directly with the for-profit corporate entity.

Generally speaking, most microfinance providers work on a non-profit level for socio-economic change. These services are generally offered to low-income and impoverished people on both national and international levels to meet a range of financial needs.

Many supporters of microfinance argue that it lifts borrowers out of poverty. But in recent years, the microfinance industry as a whole, and peer lenders in particular, have been more conservative about what their services can and cannot do. Realistically, it’s more about financial inclusion than eradication of poverty.

Creating Financial Inclusion

Critics of microfinance often come from one of two stances: The first generally states that services offered through microfinance are not on a scale that is large enough to truly make a difference – the loans are too small, the insurance inconsistent and not widely applicable, etc.

 

The second stance has it that microloans, specifically, cause greater harm than good. They argue that the interest rates are too high and many borrowers are unable to repay the loan without plunging into deeper poverty. But according to the IFAD  these rates fall well below those of local money lenders.

What microfinance does do, though, is build financial inclusion. The goal of which is to encourage markets that responsibly serve more people with more products at lower costs. By making products safer and more cost effective, consumers who couldn’t normally engage with them now have better means.

Recipients of micro financial services receive more than the direct service – they get education, savings opportunities, and the chance to address institutional inefficiencies both within their own enterprises and with larger companies — that gives them greater opportunity within their current set of means.

How Microfinance Loans Work

 

So let’s talk about those loans, specifically. How do they work, how can someone get one, and how can someone fund one?

On the borrower’s side, microloans probably don’t look too different from the kind of loans you would get from a bank. Borrowers pay them back along with interest gradually, and apply the loan money as their terms will allow.

From the lender’s side, they work a bit more like short-term loans in that they charge an interest rate that’s usually lower than that of local moneylenders, but higher than what those of us who have worked with traditional bank loans would expect.

Micro lending is, at its heart, a risky investment, and there’s no guarantee of a full return on money. Moderately elevated interest rates help the financial organizations recoup more of their investment faster, along with relying on generally cultured in social pressure and repayment options that build in more convenience for the borrower, such as payment collectors that can come to them in rural areas.

In terms of receiving a microloan, a borrower is going to have their best chance if they fall under a few conditions, specifically:

  1. Living at or below the poverty line
  2. Living in an area or working in an industry underserviced by traditional financial institutions
  3. Pursuing financial and/or social change, often through entrepreneurship

These traits are shared by most borrowers who receive money from those non-profit lenders. For those who do not meet any or all of these, a number of for-profit lenders exist that offer the same kinds of loans, often with greater inflation of rates, and often with more means for collecting.

These loans go through an application process, just as any other loan, and are often distributed by local institutions. Peer funding organizations, if involved, do not take applications for or distribute the loans, themselves.

As for those of you interested in being the funder on the peer funding side of micro lending – good for you! All you have to do is lend once, generally at a minimum set by the organization, often for less than $30.

Your loan will be gradually repaid with interest, and you can either roll it directly into a new loan, or withdraw when necessary. You’ll get to track your portfolio, follow up with your investment, and work with it like you would any other lending opportunity. A bit of philanthropy and a bit of financial education all rolled into one.

So those are the microfinance basics. It’s a familiar concept on a small scale, and while just how big a difference it makes is still to be seen, you can’t argue that micro financial companies aren’t trying for change.