Why Microfinancing Is Important to Small Business

Microfinance—also called "microcredit"—is a way to provide small business owners and entrepreneurs access to capital. Often, these small and individual businesses don’t have access to traditional financial resources from major institutions, so it is harder for them to access loans, insurance, and investments that will help grow their business.

Essentially, microfinance involves providing loans, credit, access to savings accounts—even insurance policies and money transfers—to the small business owner and entrepreneur.

How Microfinancing Works

Microfinance, pioneered by the Nobel Prize winner Muhammad Yunus, helps the financially marginalized by providing them with the necessary capital to start a business and work toward financial independence. These loans are significant because they are given even though the borrowers have no collateral. However, the interest rates for these microloans are often very high due to the risk of default.

The term "microfinance" encompasses microloans, microsavings, and microinsurance. Microfinance institutions provide small loans and other resources to business owners and entrepreneurs to help them get their businesses off the ground. Many of the borrowers are in developing countries and could otherwise not obtain a traditional loan.

Microsavings accounts also fall under the microfinance umbrella. They allow entrepreneurs to have savings accounts with no minimum balance. Microinsurance provides these borrowers with insurance at a lower rate and with lower premiums.

Financial Literacy

Sometimes, those who receive microloans are required to take training courses. These courses include bookkeeping, cash flow management, and other relevant skills.

Access to cell phones and wireless internet around the world has also lent itself to the prevalence of microfinance, since potential borrowers can use their cell phones as banking channels.

Why Is It Important?

Microfinance is important because it provides resources and access to capital to the financially underserved, such as those who are unable to get checking accounts, lines of credit, or loans from traditional banks.

Without microfinance, these groups may have to resort to using risky loans or payday advances with extremely high interest rates or even borrow money from family and friends. Microfinance helps them invest in their businesses and, as a result, invest in themselves.

Who Benefits From Microfinancing?

While microfinance can certainly benefit those stateside, it can also serve as an important resource for those in the developing world. For example, cell phones are being used as a way to bring financial services such as microlending to those living in Kenya.

It’s also made headway in the United States, where burgeoning entrepreneurs with no collateral are able to take out loans of up to $50,000 to jump-start their business ventures.

Microfinance can help women break the cycle of poverty. Often, these loans can be as small as $60. For example, a young, single mother from Paraguay took this small investment of $60 to start an empanada and snack stand. She continued building her business, repaying this loan and taking out larger loans to buy a building for her venture, complete with a refrigerator and attached home for her family. This is microfinance at its best.

In fact, women are major microfinance borrowers, making up 80% of loans in 2018, according to the 2019 Microfinance Barometer. Around 65% of total borrowers live in rural areas, which means that a large number of female microfinance borrowers live in areas with limited resources.

The microfinance industry is also growing rapidly. In 2018, there were 139.9 million microfinance borrowers, for a total of $124 billion in loans. India accounted for most of these borrows, followed by Bangladesh and Vietnam.

Does It Actually Work?

While some have lauded microfinance as a way to end the cycle of poverty, decrease unemployment, increase earning power, and aid the financially marginalized, some experts say that it may not work as well as it should, even going so far as to say it’s lost its mission.

Others argue that microfinance simply makes poverty worse since many borrowers use microloans to pay for basic necessities, or their businesses fail, which only plunges them further into debt.

For example, in South Africa, 94% of all microfinance loans are used for consumption, meaning, the funds are used to pay for basic necessities. This means borrowers aren’t generating new income with the initial loan, which means they have to take out another loan to pay off that loan, and so forth. This translates into a lot more debt.

However, other experts say that microfinance can serve as a valuable tool for the financially underserved when used properly. They also cite the industry’s high repayment rate as proof of its effectiveness.

Either way, microfinance is an important topic in the financial realm, and if done correctly, could be a powerful tool for many.

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