Microcredit: Definition, How It Works, Loan Terms (2024)

What Is Microcredit?

Microcredit is a common form of microfinance that involves an extremely small loan given to an individual to help them become self-employed or grow a small business. These borrowers tend to be low-income individuals, especially from less developed countries (LDCs). Microcredit isalso known as "microlending" or "microloan."

Key Takeaways

  • Microcredit is a method of lending very small sums to individuals to start or expand a small business.
  • Microcredit borrowers tend to be low-income individuals living in parts of the developing world; the practice originated in its modern form in Bangladesh.
  • Most microcredit schemes rely on a group borrowing model, originally developed by Nobel Prize winner Muhammad Yunus and his Grameen Bank.

How MicrocreditWorks

The concept of microcredit was built on the idea that skilled people in underdeveloped countries, who live outside of traditional banking and monetary systems could gain entry into an economy through the assistance of a small loan. The people to whom such microcreditis offered may live in barter systems where no actual currency is exchanged.

Modern microcredit is typically attributed to the Grameen Bank model, developed by economist Muhammad Yunus. This system started in Bangladesh in 1976, with a group of women borrowing $27 to finance the group's own small businesses. The women repaid the loan and were able to sustain the business.

The women in Bangladesh who receivedmicrocredit did not have money to purchase the materials they needed to make the bamboo stools that they would, in turn, sell—and at the same time, each individual borrower would be too risky to lend to on their own. By borrowing as a group, the initial financing gave them the resources to begin production, with anunderstanding that the loan would be paid over time as they brought in revenue.

Microloans can range from as small as $10 to $100, and rarely exceed $2,000.

The structure of microcredit arrangements frequently differs from traditional banking,wherein collateral may be required or other terms established to guarantee repayment. There might not be a written agreement at all.

In some instances, the microcredit was guaranteed by an agreement with the members of the borrower’s community, who would be expected to compel the borrower to work towardrepaying the debt. As borrowers successfully pay off their microcredits, they may become eligible for loans of larger and larger amounts.

Micro-Loan Terms

Like conventional lenders, micro-financiers must charge interest on loans, and they institute specificrepaymentplans with payments due at regular intervals. Some lenders require loan recipients to set aside a partof their income in a savings account, which can be used as insurance if the customerdefaults. If the borrower repays the loan successfully, then they have just accrued extra savings.

Because many applicants cannot offercollateral, microlenders often pool borrowers togetheras a buffer. After receiving loans, recipients repay their debts together. Because the success of the program depends on everyone's contributions, this creates a form of peer pressure that can help to ensure repayment.

For example, if an individual is having trouble using his or her money to start a business, that person can seek help from other group members or from the loan officer. Through repayment, loan recipients start to develop a goodcredit history,which allows them to obtain larger loans in the future.

Interestingly, although these borrowers often qualify as very poor, repayment amounts on microloans are often actually higher than the average repayment rate on more conventional forms of financing. For example, the microfinancing institutionOpportunity International reportedrepayment rates of approximately 98.9%in 2016.

Critiques of Microcredit

There have been criticisms of microcredit and the way it can be misused. For example, in South Africa,microcredit was introduced in some of the poorest communities to encourage people to pursue self-employment. However, the way it was introduced, in some instances, led to the funds being expended through consumption spending, rather than the establishment or furthering of any form of business or employment activity.

Also, the borrowers may find themselves with a magnitude of debt they cannot repay, even with the small-scale loans offered through microcredit. The problem is that the borrowers may not have a steady income source, or they plan to use the microcredit to create an income source for themselves that would allow them to pay back the financing. As a result, some borrowers have resorted to sellingoff personal property and seeking new financing to cover their previous microcredit.

Microcredit: Definition, How It Works, Loan Terms (2024)


Microcredit: Definition, How It Works, Loan Terms? ›

Microcredit is a common form of microfinance that involves an extremely small loan given to an individual to help them become self-employed or grow a small business. These borrowers tend to be low-income individuals, especially from less developed countries (LDCs).

What is microcredit and how does it work? ›

Microcredit is an extremely small loan given to those who lack a steady source of income, collateral, or any credit history. It aims to support and kickstart entrepreneurs who are unable to obtain the financial backing needed to start a small business or capitalize on an idea.

What is the definition of a micro loan? ›

Key Takeaways. Microlending is the process of connecting a borrower and a lender for a non-traditional, smaller loan. A borrower usually uses microloans if they do not have access to local financial institutions, if they have poor credit, or if they want a loan smaller than what their bank will allow.

What is microlending and how does it work? ›

Microlending, also known as microcredit, is a type of funding in which small loans are issued by individuals, rather than banks or other credit institutions. These loans can be used by entrepreneurs or business owners to get their ideas off the ground or to expand their business with a little extra cash.

What is microfinance and how does it work? ›

Microfinance refers to the financial services provided to low-income individuals or groups who are typically excluded from traditional banking. Most microfinance institutions focus on offering credit in the form of small working capital loans, sometimes called microloans or microcredit.

What is an example of a micro loan? ›

Microloans, also called peer-to-peer loans, can be used for a range of objectives related to starting a business or expanding an existing one. Examples include working capital, inventory, supplies, furniture, fixtures, machinery, and equipment.

What is a microcredit example? ›

One of the most famous examples of microcredit is the Grameen Bank in Bangladesh, founded by Muhammad Yunus. The bank has provided millions of small loans to rural poor in Bangladesh, helping them become financially independent and break out of the cycle of poverty.

How do micro loans make money? ›

Microlending companies make money from the loans when they are paid back with interest. For example, a $500 short-term loan might come with a 10% interest rate.

What is the duration of a micro loan? ›

To repay your loan amount, you can choose from tenure of up to 96 months to repay your loan amount.

Do micro loans require collateral? ›

SBA Microloans Require Collateral and a Personal Guarantee

In addition to requiring collateral, SBA microloans also require a personal guarantee, which states that a lender can go after a borrower's personal assets if they default on the loan.

What are the benefits of a micro loan? ›

Pro: Low Interest Rates

Microloans typically have low interest rates. Across all microloans, the average interest rate is about 7% to 8%. The U.S. Small Business Administration (SBA) offers microloans as well. For SBA microloans, the average interest rate is about 6.5%.

What is the difference between a micro credit and a micro loan? ›

Microcredit refers specifically to the practice of providing small loans to individuals or groups who may not have access to traditional banking services, while microfinance encompasses a wider range of financial services, including savings and insurance.

Why do microloans work? ›

Microloans typically work like traditional term loans: You receive a lump sum of capital from a lender and repay it, with interest, over a specific period of time. Repayment terms, interest rates and maximum loan amounts will vary based on your lender.

What is microfinance in simple words? ›

Microfinance is a banking service provided to low-income individuals or groups who otherwise would have no other access to financial services. Microfinance allows people to take on reasonable small business loans safely, in a manner that is consistent with ethical lending practices.

How do you operate a microfinance? ›

If you are interested in how to start micro finance company, this guide will walk you through the process step-by-step.
  1. Step 1: Conduct Market Research. ...
  2. Step 2: Develop a Business Plan. ...
  3. Step 3: Obtain Company Registration Online. ...
  4. Step 4: Obtain Licenses and Permits. ...
  5. Step 5: Set Up Your Office and Infrastructure.

Is microfinance good or bad? ›

Microfinance isn't perfect, and many of the concerns voiced about the industry are legitimate. It is, however, one of the more effective tools the world has for improving financial inclusion, which in turn can help to bring people out of poverty and assist in reaching the UN's Sustainable Development Goals.

Is microcredit good or bad? ›

What happened? Studies have shown it hasn't really lifted people out of poverty. But it's still made a difference in the lives of the poor.

What are the benefits of microcredit? ›

There are several benefits of microfinance.
  • Providing immediate funds.
  • Access to credit.
  • Better rates for Loan Repayment.
  • Provides for those who go unnoticed.
  • An opportunity to receive education.
  • Possibility of future investments increases.
  • Creation of Real Jobs.
  • Significant Economic Gains.

How does microcredit help the poor? ›

Microfinance can be a tool to help those without access to financial services access the resources they need to start or expand small businesses and build better lives for their families. Kiva lenders make an impact every day with every loan, helping to further our mission of financial inclusion for all.

What are the pros and cons of microcredit? ›

Additionally, micro loans usually have shorter terms and lower interest rates than bank loans. However, there are also some disadvantages to using a micro loan. One of the biggest drawbacks is that they can be more expensive than traditional bank loans.

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