what-is-microfinance

What Is Microfinance And How Does It Work? Microfinance In A Nutshell

Microfinance is a means of providing small business owners and entrepreneurs with access to capital.

The approach was pioneered by Bangladeshi social entrepreneur, economist, and Nobel Prize winner Muhammad Yunus.

In his book titled Banker to the Poor, Yunus explains the predicament of a woman who was making chairs from bamboo and earning only two cents per day because most of her income went to the bamboo supplier.

Yunus believed that if there was access to a more dependable source of credit, the woman and others like her would be able to lift themselves out of poverty. 

As a result, microfinance is well suited to individuals in countries or situations where traditional capital from a bank or a lender is difficult to access.

Most borrowers require access to a loan, credit, insurance, money transfer, and bank account services.

Whatever the product that is sought, it is important that the individual does not feel excluded from the financial sector.

They should also be able to take on a small but reasonable amount of debt consistent with the safe and ethical lending practices seen in more advanced nations.

How does microfinance work?

The process of microfinance starts with a microfinance institution (MFI) that lends out very small amounts of capital to borrowers.

In India, for example, the average loan amount for a 2-year repayment period is USD 200

Microfinance institutions may function as a:

  • Non-profit – in most cases, this is a non-governmental organization (NGO).
  • Mutual fund or cooperative – where members pool their resources to fund a project or initiative. 
  • Commercial company – such as a bank or non-banking financial institution.

Since most borrowers do not have credit scores or any other means of proving creditworthiness, income earned from their business activities is used to pay off the loan balance.

It’s also important to note that MFIs operate differently than traditional banking institutions because of their importance to poor or disadvantaged societies.

Indeed, the microfinance process has several distinct characteristics:

Assessment

Borrowers are assessed on whether the loan will provide the means necessary to establish a new business venture.

Human criteria are also considered, including the motivation, prior experience, or competence of the borrower.

They are never assessed on their salary or the value of their assets.

Guarantee

The loan guarantee may form a group solidarity mechanism, where each borrower in a mutual fund or cooperative serves as a guarantor for the others.

Financial literacy

To increase the likelihood that a loan will be paid in full, MFIs also work with borrowers to improve their financial literacy via educational tools.

Grouping

The loan product is also dependent on the nature of the borrower. In some situations, a single loan is offered to a cohort of individuals.

This arrangement fosters a social guarantee where each individual feels a sense of responsibility to the lender and the other members of the cohort.

Microfinance platform examples

Some of the more prevalent microfinance platforms include:

Kiva

A crowdfunded loan platform founded in San Francisco in 2005.

Users can lend as little as $25 to help small business owners launch a range of initiatives in technology, health, agriculture, and education.

To date, Kiva has funded $1.68 billion in loans.

Upstart

A micro-lender designed for millennials in the United States to help them consolidate debt, refinance car loans, or reduce their credit card balance.

Upstart uses artificial intelligence to automate the application process and assess the credit risk of each applicant.

Momentum Credit

A Kenyan company specializing in loans for small and medium enterprises.

Micro-loans are available to finance insurance premiums, motor imports, and invoice discounting where the business can receive up to 85% of the invoice value before payment.

Momentum Credit also provides financing that is Sharia Law compliant.

Key takeaways

  • Microfinance is a means of providing small business owners and entrepreneurs with access to capital. The approach was pioneered by Bangladeshi social entrepreneur, economist, and Nobel Prize winner Muhammad Yunus.
  • Microfinance is provided by a mutual fund, cooperative, non-profit, or commercial company such as a bank. Borrowers tend to be assessed on human and social criteria rather than on their income or the total value of their assets.
  • Microfinance platforms include crowdfunded lender Kiva, millennial micro-lender Upstart, and Kenyan company Momentum Credit.

Key Highlights

  • Definition and Origin: Microfinance is a strategy that offers access to capital for small business owners and entrepreneurs. It was pioneered by Muhammad Yunus, a Nobel Prize-winning Bangladeshi social entrepreneur and economist, who aimed to provide financial support to individuals in poverty.
  • Motivation Behind Microfinance: Muhammad Yunus observed the challenges faced by individuals like a woman making chairs from bamboo, who earned very little due to high expenses. He believed that access to dependable credit could help lift people out of poverty by enabling them to invest in their businesses.
  • Applicability and Need: Microfinance is especially suitable for regions or situations where traditional banking loans are hard to obtain. It targets borrowers who lack access to credit, insurance, money transfer, and banking services, ensuring they are not excluded from the financial sector.
  • Microfinance Institutions (MFIs): Microfinance begins with MFIs that provide small amounts of capital to borrowers. These institutions can be non-profit NGOs, mutual funds, cooperatives, or even commercial companies like banks or non-banking financial institutions.
  • Microfinance Process Characteristics:
    • Assessment: Borrowers are evaluated based on their potential to establish new businesses and their human qualities like motivation and experience.
    • Guarantee: Borrowers may guarantee each other’s loans, creating a sense of solidarity.
    • Financial Literacy: MFIs enhance borrowers’ financial literacy through educational tools to ensure loan repayment.
    • Grouping: Some situations involve offering a single loan to a group of individuals, fostering mutual responsibility.
  • Microfinance Platform Examples:
    • Kiva: A crowdfunded platform that allows users to lend as little as $25 to support a variety of initiatives worldwide, funded over $1.68 billion in loans.
    • Upstart: A micro-lender using AI to help millennials in the US consolidate debt, refinance loans, or reduce credit card balances.
    • Momentum Credit: A Kenyan company specializing in micro-loans for small and medium enterprises, including Sharia Law-compliant financing.

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