How It Benefits Low-Income Individuals

What Is Microfinance?

Microfinance, also called microcredit​, is a type of banking service provided to low-income individuals or groups who otherwise wouldn’t have access to financial services. While institutions participating in microfinance most often provide lending—microloans can range from as small as $50 to under $50,000.

However, many banks offer additional services, such as checking and savings accounts, while others may provide micro-insurance products as well as financial and business education. The goal of microfinance is to ultimately allow impoverished people to become self-sufficient.

How Microfinance Empowers Low-Income Individuals

Microfinance services provide much-needed financial assistance to unemployed or low-income individuals. Unfortunately, those who earn below the poverty income threshold or have limited financial resources may not earn enough income to meet the financial qualifications to conduct business with traditional financial institutions.

However, despite being unbanked, people who live on as little as $2 a day do attempt to save, borrow, or acquire credit or insurance and make payments on their debt. Thus, many poverty-stricken people typically look to family, friends, and even loan sharks—who often charge exorbitant interest rates—for help.

Microfinance lets people take small business loans safely and ethically. Although microfinancing operations exist worldwide, the majority of financing activity occurs in developing nations, including Bangladesh, Cambodia, India, Afghanistan, the Democratic Republic of Congo, Indonesia, and Ecuador. Some microfinance institutions, sometimes referred to as MFIs, focus on helping women in particular.

Essential Microfinance Offerings: Loans, Savings, and More

Microfinancing organizations support a large number of activities, ranging from providing the basics—like bank checking and savings accounts—to startup capital for small business entrepreneurs and educational programs that teach the principles of investing. These programs can focus on skills like bookkeeping, cash-flow management, and technical or professional skills like accounting.

Building Financial Literacy through Microfinance 

Many people using microfinance services must first take a basic money-management class. Lessons cover understanding interest rates, the concept of cash flow, how financing agreements and savings accounts work, how to budget, and how to manage debt.

After taking the class, customers can apply for loans. Loan officers help with applications, manage the lending process, and approve loans, just like at a traditional bank. The typical loan, sometimes as little as $100, may not seem like much to some people in the developed world, but for many impoverished people, this figure is often enough to start or sustain a business or engage in other profitable activities.

Understanding Microfinance Loan Structures 

Like conventional lenders, microfinanciers must charge interest on loans and institute specific repayment plans with payments due at regular intervals. Some lenders require loan recipients to set aside some of their income in a savings account, which can be used as insurance if the customer defaults. If the borrower repays the loan successfully, then they have just accrued extra savings. 

Because many applicants can’t offer collateral, microlenders often pool borrowers together as a buffer. After receiving loans, recipients repay their debts together. Because the program’s success depends on everyone’s contributions, this creates a form of peer pressure that can help ensure repayment.

For example, if an individual is having trouble using their money to start a business, they can seek help from other group members or the loan officer. Through repayment, loan recipients begin to develop a good credit history, which allows them to get larger loans in the future.

Although these borrowers often qualify as “very poor,” repayment rates on microloans are often higher than the average repayment rate on more conventional forms of financing. For example, the Grameen Bank in Bangladesh, one of the original microlenders, reports an average repayment rate of 98%.

Tracing the Evolution of Microfinance

Microfinance isn’t a new concept. Small operations of this type have existed since the 18th century. The first occurrence of microlending is attributed to the Irish Loan Fund system, introduced by Jonathan Swift, which sought to improve conditions for impoverished Irish citizens. In its modern form, microfinancing became popular on a large scale in the 1970s.

The first organization to receive attention was the Grameen Bank, started in 1983 by Muhammad Yunus in Bangladesh. In addition to providing loans to its clients, the Grameen Bank also suggests that its customers subscribe to its “16 Decisions,” a basic list of ways people experiencing poverty can improve their lives. The 16 Decisions touch upon a wide variety of subjects, ranging from a request to stop the practice of issuing dowries upon a couple’s marriage to keeping drinking water sanitary. In 2006, the Nobel Peace Prize was awarded to both Yunus and the Grameen Bank for their efforts in developing the microfinance system.

There are other microfinance operations around the world. Some larger organizations work closely with the World Bank, while other smaller groups operate in different nations. Some organizations enable lenders to choose exactly who they want to support, categorizing borrowers by their poverty level, geographic region, and type of small business.

The Far-Reaching Impact of Microfinance 

More than 174 million people have directly or indirectly benefited from microfinance-related operations. However, these operations are only available to some of the world’s poor, while an estimated 1.7 billion people lack access to establishing basic financial accounts.

Navigating the Debate: For-Profit Microfinance

Although there are countless heartwarming success stories, microfinance has sometimes been the target of criticism. As microfinance interest rates are generally higher than conventional banks’, critics have argued that these operations make money off people with low incomes.

In fact, some non-profit microlenders have converted to being for-profit as they’ve grown. One of the largest and most controversial is Mexico’s Banco Compartamos. The bank was started in 1990 as a nonprofit. However, management transformed the enterprise into a traditional, for-profit company ten years later. In 2007, it went public on the Mexican Stock Exchange, and its initial public offering (IPO) raised more than $400 million.

Like most other microfinance companies, Compartamos Banco makes relatively small loans, serves a predominatly female clientele, and pools borrowers into groups. The main difference lies in how it uses the funds it nets in interest and repayments. Like any public company, it distributes them to shareholders. In contrast, nonprofit institutions take a more philanthropic stance toward profits, using them to expand the number of people they help or to create more programs. 

Concerns About For-Profit Microfinancing

In addition to Compartamos Banco, many major financial institutions and other large corporations have launched for-profit microfinance departments, including Citigroup and Barclays. Other companies have created mutual funds that invest primarily in microfinance firms.

Many, including Yunus, have criticized Compartamos Banco and other for-profit peers. People fear that for-profit microfinance banks may charge high interest, trapping low-income borrowers in debt.

However, Yunus and others also have a more fundamental concern: that the incentive for microcredit should be poverty alleviation, not profit. By their very nature—and their obligation to stockholders—these publicly traded firms work against the original mission of microfinance: helping the economically impoverished above all else.

In response, Compartamos and other for-profit microfinanciers counter that commercialization allows them to operate more efficiently and attract more capital by appealing to profit-seeking investors. By becoming a profitable business, their argument goes, a microfinance bank can extend its reach, providing more money and loans to low-income applicants. For now, though, charitable and commercialized microfinanciers do co-exist.

Addressing Challenges in Microfinance

In addition to the divide between nonprofit and for-profit microfinance enterprises, other criticisms exist. Some say that individual microloans of $100 aren’t enough to provide independence—instead, they keep recipients working in subsistence-level trades, barely covering basic needs like food and shelter.

A better approach, these critics maintain, is to create jobs by constructing new factories and producing new goods. They cite the examples of China and India, where the development of large industries has led to stable employment and higher wages, which in turn has helped millions to emerge from the lowest levels of poverty.

Other critics have said that the presence of interest payments is a burden. Despite the healthy repayment rates, some borrowers can’t or don’t, repay loans, because of the failure of their ventures, personal catastrophe, or other reasons. So, this added debt can make microcredit recipients even poorer than when they started.

The Bottom Line

Microfinance offers essential banking services to low-income individuals and groups, allowing them to gain financial independence where traditional banks fall short. These services include lending, with loans ranging from $50 to under $50,000, as well as offering checking accounts, savings accounts, and financial education. Despite its benefits, including promoting entrepreneurship and community economic growth, microfinance faces criticisms. High interest rates and profit-driven motives in for-profit entities can conflict with the mission of poverty alleviation. Additionally, some argue that the small loan amounts fail to provide a viable path to long-term economic independence for borrowers. Understanding these advantages and challenges is crucial for stakeholders seeking to engage in or develop microfinance initiatives.