Among the multitude of financing solutions available to small business owners, microlending is one of the more accessible. Also called microcredit, microlending has been gaining popularity over the last five years—and for good reason.
What is microlending?
Microlending is the practice of giving small loans—from $25 to a few hundred dollars—to business owners in need.
Microlending falls under the umbrella of microfinance, which refers to any financial help given to people who wouldn’t otherwise benefit from traditional financial institutions. Microloans began as a way to help business owners and entrepreneurs who either 1) have no access to funding where they live or 2) can’t get funding from banks because of their lower credit scores.
Thanks to the internet and the peer-to-peer (P2P) lending economy—where individuals give each other loans—microlending has become a global phenomenon. Loaning small amounts of money goes especially far in developing nations and impoverished places where aspiring entrepreneurs have little government assistance to start businesses.
How does microlending work?
Microloans work like most other term loans: borrowers get a certain amount of cash upfront that they have to pay back—with interest—over a specific period of time. Unfortunately, interest rates on microloans tend to be high, with the average global interest rate hovering around 35%. That’s because it’s riskier to lend to entrepreneurs with poor credit; plus, borrowers often don’t put up collateral.
Unlike a bank loan, microloans can come with unique stipulations for the borrower. For instance, many microlenders require borrowers to take an educational workshop or business class before they can receive their funding.
Because the majority of traditional financial institutions don’t see the payoff in microlending, most microlending occurs on P2P platforms. However, there are also a handful of dedicated microfinance institutions (MFIs), such as 51Give in Beijing and Grameen Bank and BRAC of Bangladesh.
Certain countries have also developed their own microloan programs. In the United States, the Small Business Administration (SBA) has a microloan program designed to help women, low-income, veteran, and minority entrepreneurs get access to working capital, supplies, or equipment. The average SBA microloan is around $14,000 and has a 6.5% interest rate.
What are the benefits of microlending?
Microlending can help entrepreneurs from marginalized communities or impoverished areas get their businesses off the ground, which in turn gives struggling individuals and families the chance to earn a better income. In the long term, microlending can help create job opportunities, reduce poverty, and further education.
As a microloan lender, there’s a small financial incentive in the form of interest, but there’s also a chance that a borrower could default on the loan. For that reason, most lenders spread out their investments to minimize their risk. Instead of contributing $1,000 to one single borrower, for example, a microlender might loan $100 to 10 different borrowers.
It’s important to note that most microlenders don’t dabble in microfinance for the potential ROI. Rather, the main benefit of microlending is helping a worthy business owner launch or develop their company.
What to know as a borrower: risks and benefits
If you need a small amount of money for your business and have had a hard time getting help from traditional financial institutions, microlending could be right for you. Its primary appeal is accessibility and ease. If you have a promising business plan and a compelling story, getting a microloan via an MFI or P2P website may be easier than turning to a bank.
However, there are risks to taking a microloan. Funding isn’t always fast. Depending on your location or your lender’s requirements, you could wait weeks or months before getting your money. Plus, if your business doesn’t take off, you could be stuck paying high interest rates that trap you in a debt spiral.
Before you make a choice, consider the following factors:
- Your location and access to funding
- Your credit score
- How much money you need
- Your business’s profit potential
How to become a microlender
There are a few ways to get started. If you want to earn interest and/or participate in your borrower’s business development, consider a P2P lending site like Prosper or Lending Club. You can also search for lenders using the SBA’s list of local microlending organizations by state.
On the other hand, if you don’t care about interest or don’t want to be involved in the business’s growth, you can sign up with Kiva, an MFI that takes a more hands-off approach to giving. You may also want to look into crowdfunding, a funding solution that helps businesses raise money through charitable donations. You won’t get your money back, but you may be eligible for rewards or benefits if you pledge a certain amount of cash to an entrepreneur.