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

What is microfinance?

Microfinance is a way to provide capital to low-income business owners who may be excluded from traditional credit and lending options. Microfinance offerings include small loans – called microloans, savings accounts (microsavings) and insurance policies (microinsurance). 

Various lenders offer microloans, including nonprofit organizations, banks and credit unions. In the U.S., the Small Business Administration (SBA) acts as a third party to get microloans into eligible borrowers’ hands. The SBA provides funds to specific intermediary lenders that administer the program. 

According to the SBA, microloans can be up to $50,000, though the average loan amount is $13,000. Owners can spend the money on many business needs, such as buying inventory, supplies, furniture, fixtures, machinery and equipment. Owners can’t use microloans to pay off existing debt or buy real estate.  

“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.

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What is the history of microfinance?

According to MicroWorld, microfinance has been around for centuries and even longer in Asia as an informal lending type. What we know as microfinance today started in Bangladesh sometime in the 1970s. 

“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 explained. 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 the women $27 of his own money, covering the borrowing needs of all 42 women. By selling their stools at a fair price, they were able to climb out of their debt cycle. (Muhammad Yunus and the Grameen Bank he founded won the 2006 Nobel Peace Prize for grassroots efforts to lift millions of people out of poverty.)

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 money influx could help lift them out of poverty. The operation was successful: 885 loans helped create or stabilize 1,386 new jobs. 

Today, Accion has microfinancing programs throughout Latin America, the U.S., Africa and many more places. And, in general, global microfinance is big business. According to the Global Microfinance Industry Report, the market is expected to reach a value of $394.8 billion by 2027.

Where can I get microfinancing?

The SBA is an excellent place to start looking for microfinancing, but you can also explore this specialized financing directly via nonprofit organizations and banks. Popular microfinancing institutions include Accion, GE Consumer Finance, Citi Inclusive Finance, Kiva and BRAC. 

When you speak to lenders and are granted a small loan, you can also expect assistance 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.” 

How do I get approved for microfinancing?

While approval is ultimately the lender’s decision, there are some steps you can take to increase your chances of receiving microfinancing. 

1. Write a business plan. Lenders want to see that you take your business seriously and have a plan; they want to work with people invested in their success. Every successful business plan includes a company overview, introduction, mission statement, market and industry analysis, marketing plan, and operations plan. [Use our free business plan template and guide to write your plan.]
2. Maintain good credit. Even though you currently may not have much money, a good credit score makes an excellent impression. Carefully review your report, ensuring it doesn’t contain any false information. If it does, send out disputes accordingly. [Related article: 8 Ways to Build Your Business Credit]
3. Give 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 if you don’t repay the loan. If you’re confident your business will succeed, providing a guarantee or collateral makes sense. [Related article: What Is Business Collateral?]
4. Invest some of your own money. A business owner who makes a personal investment in their company along with a microloan shows they’re serious about their business’s success.

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

Microfinancing interest rates can vary wildly compared to traditional bank interest rates, but they’re usually higher for two primary reasons: 

• Microfinancing borrowers are a higher risk. Microfinancing is designed for low-income borrowers, who are a higher risk to banks. As standard lending logic follows, the higher the investment risk, 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 suffocate small businesses, ensure the lender receives some return on investment. 
• Microfinancing is more expensive for the bank. 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, loan officers often have to travel to businesses in low-income areas instead of potential borrowers visiting their local bank branch to inquire about loans. 

While microfinance 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 their means.

What’s the difference between microfinance and microcredit?

While they may sound similar, there is a crucial difference between microfinance and microcredit: Microfinance encompasses a broad offering of financial services for low-income communities, while microcredit specifically means 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 less advantaged communities across the developing world to start their own businesses and enter the economy. 

Of course, microfinance also embodies all these elements. It also includes a broad range of other financial services, including checking and savings accounts, microinsurance, and business education. 

Microfinance FAQs

Can I get SBA microfinancing if my business is a nonprofit organization? 

In general, no. Your enterprise needs to be a for-profit small business. Currently, the only exception is nonprofit child care centers.

What should I do if I’m denied a microloan?

You could be denied because your credit score was too low, you didn’t have enough collateral or you couldn’t prove that you could repay the loan. Read the notice explaining why your application was denied, and then work on the identified problem.

What happens if I can’t pay my microloan?

Almost all lenders report to the three major credit reporting agencies, so your credit report will reflect missed payments. Because payment history is the most important credit reporting factor, your credit score will likely go down. If your loan is backed by collateral, the lender may claim it if you default. However, if there is no collateral, the lender will have a more difficult time collecting the debt and will most likely send it to a collection agency. 

Can a microloan help me build credit? 

Yes, as long as the lender furnishes the credit bureaus with your account activity. If building credit is one of the reasons you’re pursuing a microloan, ask the lender first if it reports loan activity to the credit reporting bureaus. If it does, making all your payments on time and eventually paying off the loan will help create a positive credit history and raise your credit score. 

Erica Sandberg and Rissa Ann contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.