Small business owners and members of underserved communities often struggle to secure financing with traditional lenders. But hearing a “no” from a bank or financial institution isn't necessarily the end of the line—there's another option, called microlending.
Started in 1976, microlending is an initiative designed to help small businesses advance or expand by giving them “microloans” which are much smaller than those offered by banks and traditional lenders. Today there are both private and governmental microlenders, giving business owners the opportunity to compare and choose the most beneficial alternative.
This article will tell you all you need to know about what microlending is, how it works, its pros and cons, and how to apply for a microloan.
What is microlending: Definition
Microlending is a non-traditional way to grant a small-dollar loan called a microloan to small business owners. The amounts are typically a few hundred dollars or less, but can range from $50 to $50,000.
Microlending opportunities are typically directed towards entrepreneurs who don't qualify for traditional financing for reasons such as limited credit history, lack of collateral, or even wanting a smaller amount than banks would lend.
“Even small amounts of money can make a big difference,” says Andrew Lokenauth, financial specialist and founder of Fluent In Finance and The Finance Newsletter.
Typically, microloans are offered to women entrepreneurs, minorities, and business owners in developing countries or low income communities. “Women tend to have higher repayment rates on microloans compared to men, making them attractive borrowers for lenders,” Lokenauth says.
How does microlending work?
Much like with a traditional loan, with a microloan you repay the borrowed amount with interest in a determined period of time. However, there are some key differences between microlending and traditional business loans. Not only is the amount of the loan smaller, but the lender isn't a bank, but an organization or person.
Also, borrowers can only use the money for business purposes, and nothing else. “Microlenders provide tiny loans to help people start or grow a small business, pay for a business emergency (e.g. leaking, roof repair), or cover other important expenses,” Lokenauth says.
In some cases, the interest rates are relatively lower than what's offered in traditional loans, but some microloans will have the same or even higher rates. Usually borrowers have a shorter period of time to finish the repayment, but it varies based on the amounts borrowed and the lender.
“The loans are usually short-term, with repayment periods of six to 12 months,” the expert says. For instance, Kiva, a nonprofit organization that expands access to capital to underserved communities globally, lends up to $15,000 at 0% interest.
Assistance isn't limited to money. Microlenders often provide other forms of support, such as counseling, mentorship, and training “to help ensure the loan is used effectively and the business can succeed,” Lokenauth says.
Ascendus, for example, not only lends up to $50,000 with 6% to 9.99% interest rate, but also helps U.S. based business owners write a business plan and connect with local partners and government agencies.
Pros and cons of microlending
Like any business decision, taking advantage of microlending has its pros and cons. Here's what to consider before applying for a microloan:
Pros
- Access to capital you wouldn't have with traditional financial institutions
- Relatively low interest rates compared to other alternative financing
- Potential access to training, mentorship, and other resources
Cons
- You're limited on how you can use the microloan money
- Interest rates, even if low, can trap borrowers in a cycle of debt
- Smaller monetary amounts and shorter repayment periods than traditional financing
There are also pros and cons for lenders. On the bright side, microlending is an “opportunity for lenders to earn a financial return while also creating social impact,” Lokenauth says. On the down side, there could be “high administrative costs for the lenders, which can limit profitability, and risk of default or non-repayment by borrowers—though microlenders try to mitigate this.”
How to get a microloan in 4 steps
The process to get a microloan in the U.S. varies depending on the lender. Usually, each lender has their own criteria and selection method. However, there are some basic steps every borrower must follow in order to apply for a loan.
1. Search and choose a microlender
Search for microlenders in your local community or online. A great place to start is the U.S. Small Business Administration (SBA) list of microlenders. You can filter your search by state and quickly find organizations in your area, as well as their contact information and address.
2. Understand the eligibility criteria
Before applying, carefully review the microlender's eligibility criteria. It may be overwhelming in the beginning, but it can save you a lot of time down the road by preventing you from applying for a loan your business doesn't qualify for.
The qualifying criteria might include:
- Age
- Credit score
- Credit history
- Business revenue
- Previous bankruptcies
- Business type
For instance, microlenders like LiftFund don't provide loans for adult entertainment companies. Kiva doesn't fund businesses that engage in multi-level marketing or direct sales, or pure financial investing (e.g. stocks). Location criteria can also vary. While some lenders fund international business, other lenders focus on U.S. based businesses—with some operating nationally, and others focusing on a state or region.
3. Fill out an application
If you check all the requirements boxes, the next step is completing your application. “It will likely require information about your business, financial situation, and intended use of the loan,” Lokenauth says.
You might also be required to provide documentation that supports the application. “Prepare any required documentation, such as a business plan, financial statements, or collateral,” he says. Always double check the information provided to avoid any mistakes that could diminish your chances of being approved and submitting your application.
4. Prepare for the approval process
After you submit the application, there's nothing else to do but to prepare for the approval process in case you're selected. In some instances, it may involve an interview or site visit, Lokenauth says. If you're approved, the lender lays out what the next steps are going to be.
FAQs
How much is a microloan?
Microloans typically range from $50 to $50,000. The exact amount varies depending on the lender and their specific budget.
What is the concept of microloans?
A microloan provides financial support with small-dollar loans to small business owners that can't get financing through traditional channels. Microloans also offer educational resources (e.g. mentorship, training) to help you advance your business.
How profitable is microlending?
The profitability of microlending can vary, Lokenauth says, though generally, it's quite profitable for lenders. “Microlenders typically earn interest rates in the range of 10-30%, which can be quite high compared to traditional bank loans,” he says. However, there are a set of costs to take into account.
“The administrative costs of underwriting, servicing, and monitoring these small loans can also be significant, limiting overall profitability,” Lokenauth says. That aside, the end goal should be the action's impact. “The true ‘profit’ of microlending is in the positive social and economic impact it has on borrowers, their families, and their communities.”
Is microlending risky?
Microlending can be risky both for lenders and borrowers. Lenders have the risk of borrowers not repaying their loans, which along with the administrative costs can diminish the profitability. Borrowers risk taking a loan they may not be able to honor in case the investment doesn't make the business succeed, which can snowball into a lot of debt.
What is a real life example of microlending?
Picture this: Ana recently opened a children’s bookstore in her community. It needs some TLC and appropriate furniture and decoration for the kids and their parents. Ana applied for a loan with a traditional bank, but got denied due to her short credit history and low income.
She finds out about microlending opportunities through a Google search and decides to apply for a microloan with a SBA approved institution. After going through the application and approval process, she is provided with a loan of $1,000 at 6% interest to repay in 12 months, which fits perfectly with her budget.
Since the money can only be used for business-related expenses, she uses it to buy the furniture and some paint to color the walls. Ana also takes advantage of a mentorship program on business development and management provided by the lender, which helps her make the bookstore profitable and more impactful for the community.
Are microloans a good idea?
Yes and no. Microloans can be great for small businesses needing a little financial incentive to grow, but they also come with some downsides. There are limitations on how you can use the money and the timeline to make the repayments are usually short—which could be difficult for business owners that don't make much profit yet. Evaluate your options carefully before making a decision.
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