Microlending: Definition, How It Works, Risks & Rewards (2024)

What Is Microlending?

Microlending is the method of issuing small loans called microloans to small business owners. These small business owners—often in developing countries—may not have access to traditional financial products or financial institutions. Instead, these small businesses work through non-traditional loan service channels to secure financing needs.

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.
  • Investors turn to microloans to earn higher rates of return and diversify their portfolios across different types of debt and different loans.
  • Microlending is heavily supported by peer-to-peer lending digital capabilities that connect borrowers, investors, and lending platforms across the world.
  • There are many different microloan platforms online, each with varying loan requirements, fees, and policies.

How Microlending Works

The origins of microlending are often tied back to Grameen Bank. Founded in 1976 by Muhammad Yunus, the bank would make small loans to Bangladeshi women who made baskets. This process required a specialized lending institution to be in the vicinity of the borrower to facilitate and oversee the loan.

Microlending is prevalent through government financing as the United States Small Business Association also runs a microloan program. To apply for a loan, a small business must often meet with a local intermediary. This intermediary review's the business's application including evaluating a company's creditworthiness and compliance with loan requirements. Microloans through the SMA may come with the requirement to fulfill training requirements to secure financing. Though microloans can be issued for up to $50,000, the average SBA microloan is $13,000.

Today, microloans are heavily digitized to introduce new lenders to the space. Private microlending platforms often require a borrower to select a loan purpose and loan amount. Upon receipt of the full application, the lending platform will assess the borrower's creditworthiness and assign terms to the loan. Some microloan platforms will solicit investments from a variety of private investors before funding the loan.

Similar to other loan products, a borrower often has amortizing payment schedule. This schedule often dictates a fixed payment amount, although the payment usually gradually increases the amount of principal paid each month and gradually decreases the amount of interest paid each month.

As a result of the COVID-19 pandemic, there was a statistically significant increase in the number of microloans applied for as well as an increase in the amount of credit requested.

Peer-To-Peer Financing

The peer-to-peer economy has revolutionizedthe way people do business, and the financial sector has seen some impressive advancements leveraging P2P applications. Through peer-to-peer financing, microloans are now small loans that are issued by individuals rather than banks or credit unions. These loans can be issued by a single individual or aggregated across several individuals who each contribute a portion of the total amount.

Through peer-to-peer financing, individual investors can select whom they'd like to lend money to. Lenders are often required to provide a minimum amount of capital (often as low as $25). Lenders are provided an overview of the borrower's credit and financial profile. In peer-to-peer financing, the borrower has no say in who the lenders are; the borrower can only select the peer-to-peer lending platform that will facilitate the loan.

Prosper, the first peer-to-eer lending marketplace in the United States, was founded in 2005. As of May 2022, it has facilitated more than $21 billion in loans to over 1,250,000 people.

How Do Consumers Use Microlending

Microloansmayserve one of two main purposes. The first is to help small businesses in Third World countries start their operations. In these situations, there is often no financial institution physically available in the geographical area. The lenders are individuals who pledge a certain amount of money to loan out to a deserving entrepreneur in another country.

Companies likeKiva administer microlending for these humanitarian purposes. Borrowers will describe the type of business they wish to start, how it will operate, and present a business plan outlining day-to-day operations. Borrowers will often also feature a personal story and a short biography.

The second purpose is to lend to individuals who may have bad credit and cannot obtain credit from a bank or who seek to borrow small amounts of money that are below the amounts required by a bank. Lending Club and Prosper are two companies that administer peer-to-peer microlending for these purposes.

A borrower may seek funding for any number of reasons, which are made explicit to potential lenders. If the lender does not trust the borrower they will elect not to fund that particular loan. In some cases, loans may not be fully funded because they cannot attract enough lenders to contribute. These companies typically earn a profit bycharging fees to originate and maintain loans that are then added to the borrower's interest rate.

Microlending Risk and Reward

There are specific reasons a borrower and a lender may be interested in entering into a microloan. Often, an advantage for one party is a disadvantage for the other. Let's review the pros and cons for both.

Microlending for Borrowers

Microlending has been facilitated by the rise of the internet and the worldwide interconnectivity that it brings. People who wish to put their savings to use by lending and those who seek to borrow can find each other online and transact. For this reason, it is often easier for a borrower to secure credit because there are now more lenders interconnected across the globe than ever before.

The credit rating of borrowers is imputed using data (including whether or not the borrowerowns a home), a credit check or background check, and repayment history if the borrower has participated in microloans in the past. Even those with excellent credit scores may expect to pay slightly more than traditional credit.

Because of the short-term nature of microloans, the borrower is often not required to post collateral. However, these loans may have a much shorter payback timeframe compared to other loans. In addition, the borrower may be restricted on how they are allowed to use the funds.

Microlending (for Borrowers)


  • Able to secure financing whereas the borrower may not quality for traditional loans

  • Typically required to provide little to no collateral for the loan

  • Often able to secure financing quickly assuming you meet necessary requirements

  • May be accompanied by training requirements that help you with financial management


  • Will likely have short repayment term (sometimes as little as one year)

  • Are often limited on what you are allowed to use the microloan for

  • Able to only secure a small amount of financing (usually up to $50,000)

  • No guarantee of securing financing should your peer-to-peer platform not full fund

Microlending for Investors

If a borrower defaults, the lender may expect little or nothing to be recovered. On Prosper.com, the best-rated borrower can expect to pay a minimum of 7.99% annually on a loan, and the riskiest borrower will pay an interest rate of up to 35.99%. If an investor thinks that 7.99% (less fees) for a relatively safe loan is worth the risk, the loanmay produce outsized returns compared to other forms of lending.

Because of the inherent risk of any single microloan, lenders often invest only a small amount per loan but may fund a portfolio of many dozens of microloans. Therefore, any individual borrower may find their loan is funded by a large number of lenders, each contributing a small percentage of the total amount. By spreading the risk across a wide array of loans with different credit qualities and other attributes, lenders can ensure that even if one or two loans default, their portfolios will not be completely wiped out.

Although lenders may diversify across an array of loans, all microloans through peer-to-peer lending platforms are subject to the same economic risk. For example, the COVID-19 pandemic was statistically shown to broadly increase the likelihood of a borrower defaulting on a loan. Other widespread macroeconomic impacts like monetary policy or global conflict can often not be diversified away across different microloans.

If investors are comfortable with the risk, it is often very easy to get started with microloan investing. Most lending platforms will require investors to create a profile, validate their identity, and confirm their tax information. These microloan platforms will then communicate investment opportunities, oversee the administration of the loan, and provide tax forms when appropriate.

Microlending (for Investors)


  • Able to passively invest through through automatic investing on some platforms

  • Can control your level of diversification across borrower types, locations, and needs

  • Get external management of loans; payments are automatically applied to your account

  • Able to collect higher interest rates compared to other fixed-income securities


  • Will be assessed service fees on payments collected through lending platforms

  • Not able to recover losses easily as microloans are often unsecured

  • May incur higher risk of loss depending on the borrowers to loan to

  • Are subject to a lending platform's review process, screening of applicants, and loan policy

Microlending Organizations

As technology continues to innovate, more organizations have entered the microlending space. Although the list below does not encompass all microloan options, it should provide both borrowers and lenders a good overview of who the major organizations are in the industry and how they may compare to each other.

  • LendingClub: Microloan terms are between one and five years. Investors are assessed a 1% fee on all payments received, and microloans range from $1,000 to $40,000.
  • Peerform: Microloans begin with rates as low as 5.99% with a maximum loan value of $25,000. There are no prepayment penalties on the loans with a maximum term length of five years.
  • Upstart: Microloan investors must be accredited and requires minimum investments of $100. All payments received are subject to a 0.5% annual fee. Loan terms are often either three years or five years.
  • Prosper: Microloan investing starts at $25 with an annual loan servicing fee of 1%. Investors are not permitted to invest more than 10% of their net worth.
  • StreetShares: Microloans start at $2,000, although small businesses can not require more than 20% of their company's annual income. Loan repayments occur every week.
  • Funding Circle: Microloans are paid in monthly installments, and the platform specializes in small businesses. Investors must deposit at least $25,000 into an investment account before allocating as little as $500 to individual loans.
  • Kiva: Microloans are as small as $400, but investors can finance as little as $25. This international nonprofit lender specializes in global small business lending.

Is Microlending a Good Investment?

Microlending is a good investment for some investors. It is a way to further diversify your income, and microloans generate cash flow returns. Microloans can often have higher rates of returns compared to other fixed-income investments.

The downside to microloans is they may be riskier depending on the borrower's creditworthiness. Microloans are also subject to the lending platform's policies, and investors often must pay higher administrative fees compared to the fees for other debt or bond investments.

What Are the Benefits of Microlending?

For a borrower, microlending may be the only way they can secure financing. Microloans are often given to borrowers even if they have bad credit or if they want a loan smaller than what is allowable by traditional financial institutions.

For an investor, microlending allows for further portfolio diversification. The investor also has greater control over how much money to invest and to whom they want to give the loan to.

Is Microlending the Same as Microfinance?

Microfinance is a broader term that describes the entire spectrum of financial services. These financial services are often provided to individuals who lack access to local banking, insurance, or financial advisory services. One branch of microfinance is microlending, the act of securing loans for these individuals.

What are Microlending Policies?

Every lending institution will have its own microlending policies, so be sure to review lending contracts before you borrow funds or invest funds. In general, microloans are often shorter-term loans that do not extend beyond five years.

Microloans usually don't require collateral, and the interest rate assessed on a loan will depend heavily on the credit history and financial profile of the borrower. A lending platform may charge administrative fees to process the loan for the borrower or facilitate payment collection for the investor.

The Bottom Line

Microlendingis a financial innovation made possible by technology and thepeer-to-peer economy. People looking to lend money to earn potentially high returns may fund borrowers who either have no access to credit dueto geography or cannot get credit from traditional sources,such as banks or credit unions.

Microlending: Definition, How It Works, Risks & Rewards (2024)


Microlending: Definition, How It Works, Risks & Rewards? ›

Microlending Benefits and Risks

What are the risks of microlending? ›

One of the biggest risks is that you could end up paying more in interest and fees than you would with a traditional loan. This is because micro loans typically have higher interest rates than traditional loans. Another risk is that you could end up in a cycle of debt if you can't repay your loan on time.

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 positive impacts does microlending have on local economies? ›

Fostering entrepreneurship

Microloans provide entrepreneurs with money for the supplies, infrastructure, inventory, marketing, and more that they need to succeed. This means that even those without wealth, access, or privilege can turn a bright idea into a thriving, profitable business.

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.

Is it high-risk to start a micro loan business? ›

Another risk of micro loans is that they often come with high interest rates. This is because micro loans are considered to be high-risk loans. The higher interest rates can make it difficult to repay the loan, especially if your businessisn't doing well.

What are the three main risks for lenders? ›

The major risks faced by banks include credit, operational, market, and liquidity risks.

What is an example of microlending? ›

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 are the cons of a micro loan? ›

One of the biggest disadvantages is that the interest rates on these loans can be high. This means that you will need to repay the loan plus interest, which can be a challenge if you are on a tight budget. Another disadvantage of a micro loan is that they are often short-term loans.

Are micro loans a good idea? ›

While microloans may be just right for some small businesses, they are typically best for borrowers with limited working capital and little to no credit history.

How to make money with micro loans? ›

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. At the end of a year, the borrower would need to repay $500 + 10% of $500 = $500 + $50 = $550, meaning that the lending company would make a profit of $50.

Is microfinance good for the poor? ›

However, an increasing number of serious studies are suggesting that microfinance can produce improvements in a range of welfare measures, including income stability and growth, school attendance, nutrition, and health.

Who benefits the most from microloans? ›

Microfinance services are provided to unemployed or low-income individuals because most people trapped in poverty, or who have limited financial resources, don't have enough income to do business with traditional financial institutions.

What is the biggest benefit of microfinance? ›

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.

Why do people do microfinance? ›

The most important function of microfinance in India is to provide small business owners with access to money. As was already said, micro finance company India offers access to loans, insurance, and savings accounts. By providing them with loans, the microfinance philosophy focuses on women as well.

What is the goal of microfinance? ›

The objective of microfinance is similar to that of microcredit; its goal is to provide financial services to help encourage entrepreneurs in impoverished nations to act on their ideas and obtain the financial tools available to do so and to eventually become self-sustainable.

What are the cons of microloans? ›

One of the biggest disadvantages is that the interest rates on these loans can be high. This means that you will need to repay the loan plus interest, which can be a challenge if you are on a tight budget. Another disadvantage of a micro loan is that they are often short-term loans.

What is a negative of microfinance loans? ›

There are some cons regarding microcredit, including too much pressure to repay loans, a large suicide rate among borrowers, and severe debt levels. A contributing factor to the disadvantages is the high interest rates on some microcredit loans – rates can be 30% or even higher.

Is microlending a good investment? ›

It is a way to further diversify your income, and microloans generate cash flow returns. Microloans can often have higher rates of returns compared to other fixed-income investments. The downside to microloans is they may be riskier depending on the borrower's creditworthiness.

Which loan has the highest risk? ›

Types Of High-Risk Loans
  • Payday Loans. Payday loans are short-term loans typically limited to smaller amounts up to $500. ...
  • Title Loans. Car title loans are secured by your vehicle's title, which the lender keeps as collateral until you can pay off the loan. ...
  • Pawn Shop Loans. ...
  • High-Risk Personal Loans.
Mar 22, 2024

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