The concept of microfinance offers banking services to groups that wouldn’t otherwise be able to access financing. What are microfinance loans, and who are they best suited for? We’ll explore the answers to these questions below.
Microfinance definition: what are microfinance loans?
Microfinance is a way to work outside the usual restrictions to provide capital to small businesses or individuals who wouldn’t normally be eligible. Whether due to poverty, geographic location or other disadvantages, it’s difficult for many would-be entrepreneurs to access insurance, investments, and loans. Microfinance bridges the investment gap so that these types of businesses can grow.
Microfinance loans are particularly relevant in developing countries or impoverished communities, where individuals would have no way to access a bank. In fact, 50% of worldwide households have no access to banking services, which means they have nowhere to place savings for investment purposes. The coin was termed by Nobel Prize winner Muhammad Yunus back in the 1970s, and has grown since then to incorporate a full-scale range of economic tools.
How does a microfinance loan work?
A microfinance loan is used to give marginalised individuals the capital needed to start up a business or otherwise establish financial independence. While traditional loans require a good credit rating or collateral, microfinance loans are issued without these usual eligibility requirements. They’re given with the understanding that there is a high risk of default, and as a result the interest rates are usually quite high. This practice often takes place in developing countries where the cost of establishing a business is lower than it would be in the UK or US. As a result, a microfinance loan might be as little as £2 or £3 in some cases.
In return for the loan, international microfinance institutions might require that recipients take training courses to improve their financial literacy. This might include topics like cash flow management or bookkeeping skills. Along with business training, institutions offer ongoing technical support to clients.
Microcredit vs. microfinance: what’s the difference?
When reading about microfinance, you’ll also see references to microcredit. These terms are closely related, but the microfinance definition is broader. While microcredit refers solely to loans, microfinance involves a wider package of financing for small businesses. These include services like insurance and savings facilities as well as microloans. For example, in the case of a microfinance savings account, entrepreneurs can open a bank account without any minimum balance.
The importance of microfinance
Microfinance helps level the playing field for small businesses and entrepreneurs who come from underserved backgrounds. Rather than turning to payday lenders or high-interest loans that they’re unlikely to be able to repay, business owners can access capital for growth.
Funding entrepreneurs without collateral brings new points of view to the business table and can spark fresh innovation as a result. From food trucks to app developers, giving small businesses funding creates a fairer and more diverse free market.
From a global perspective, microfinance lending drives developing economies forward. As smartphones become widely available worldwide, individuals are able to access bank accounts and grow financial literacy. There’s a particular focus on providing microloans to women, who in 2018 alone made up 80% of loan recipients. The majority of these women live in rural areas and wouldn’t otherwise be able to access traditional financing for their business ideas.
Results of microfinance
Does the concept of microfinance really pay off in real life? Proponents link it with many lofty ideals, from ending the poverty cycle to decreasing unemployment figures and putting income back into the economy. Due to the high risk of default, microfinance loans don’t always hit the mark. Individuals in poverty might need to use their funding for necessities rather than starting up a small business, which means they’re not able to generate new income.
However, when directed to small businesses and entrepreneurs, microfinance can be a powerful tool for growth. It can even provide a long-term solution to those living in poverty, breaking the cycle for future generations.
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