What are Microloans, and How Do They Work?
Microloans have become popular for small and medium-scale entrepreneurs who seek funding for their businesses. The loans are small, hence the term micro in their name, and they are catered to individuals or businesses who may not qualify for larger loans. Micro loans have been around for a while, but they have gained more popularity in recent times.
What are micro loans?
Microloans are small, short-term loans that are given to individuals or businesses that may not qualify for larger loans. These loans usually range from Rs.500 to Rs.50,000, with repayment terms that are often less than two years. Microloans are granted by specialized microfinance institutions or non-governmental organizations (NGOs) that are dedicated to serving small and medium-scale entrepreneurs.
How Do They Work?
Microloans are typically granted to individuals or businesses that are considered high-risk clients by conventional lending institutions, such as banks. These individuals or businesses usually do not have collateral to secure larger loans. As a result, microfinance institutions focus on the capacity of the borrower to make profitable use of the funds based on their business ideas and prior experience.
Before granting a micro loans microfinance institutions carry out a thorough review of the borrower’s business plan, financial statements, and credit history. They also take into consideration the borrower’s personal character, business experience, and market knowledge.
The microfinance institution then disburses the loan to the approved borrower, based on the repayment period, which is usually a few months or up to two years. During this time frame, the borrower is expected to repay the loan with interest, generally at a higher rate than conventional bank loans.
Who are the recipients of Microloans?
Microloans are mainly used by entrepreneurs who operate businesses that may not have the capacity to qualify for conventional bank loans. The businesses often have little or no operating history, little collateral, and/or poor or no credit history. Microloans are also targeted at individuals and businesses that carry out income-generating activities, i.e., small agricultural or retail centers. The target recipients of microloans are generally individuals who reside in developing countries.
Apart from smaller entrepreneurs in developing countries, microloans are also useful for small and medium-scale businesses (SMEs) in developed countries. These SMEs’ inability to secure loans from conventional banks due to the lack of collateral or credit history makes microloans an attractive option for their financial needs.
Types of Microloan Institutions
Microfinance institutions are usually specialized institutions that cater for small businesses and micro-enterprises. They tend to breakdown into three types: NGO-owned, public enterprises, private companies, and cooperatives. The primary objective of microfinance institutions is to provide access to financial services to those who have little or no access to conventional banking services.
NGO-owned microfinance institutions are run by a charitable or non-profit organization. The founders of these institutions tend to aim to support people in poverty and those who are unable to access banking services. Their interest rate is usually lower than other types of microfinance institutions.
Public enterprises obtain funding from the government, which allows them to provide loans to individuals and businesses in need of funding. These institutions help develop businesses and encourage entrepreneurship, particularly in areas that are underdeveloped.
Private companies function similarly to traditional banks, where they gain profits by providing lending services to customers. Their interest rates are generally higher than NGO-owned microfinance institutions, but lower than traditional banks.
Cooperatives are a member-owned fund. Members have a say in the decision making of the institution and can also benefit from its benefits. Cooperatives are not strictly limited to providing financial services; they also provide other essential services, such as educational aids and health support.
Advantages of Microloans
One of the main benefits of microloans is the accessibility and availability of the loans to entrepreneurs who do not have access to conventional banking services. Microloans increase the chances of small businesses to grow their companies and increase their income level, ultimately reducing poverty rates.
Microloans enable small scale entrepreneurs to avoid the pitfalls of predatory lending from informal moneylenders who charge high-interest rates. These high rates make it difficult for the borrower to repay, which can result in desperate financial situations.
Microloans may come with lesser bureaucratic procedures required to obtain the loans when compared to traditional bank loans. The flexibility of the repayment period and amount of loan amounts can also make microloans more accessible to potential borrowers.
Conclusion
Microloans are small short-term loans that are given for business purposes to individuals and small businesses that may not qualify for traditional bank loans. Microfinance institutions offer these loans at interest rates higher than traditional banks due to the high-risk nature of these loans. Microloans increase the likelihood of small businesses to grow, increase their profits, and contribute to an increase in income levels.
The accessibility and availability of microloans make it an attractive option for entrepreneurs who have little or no access to formal banking services. Microfinance institutions offer the service through different methods, which cater to different individuals’ needs. Microloans enable SMEs to access funding without risking collateral and without needing large amounts of previous experience. Therefore, microloans have become increasingly popular and more accessible to a wider demographic globally.