How Does Microfinance Work

If you’re interested in microfinance, then you’ve probably already researched the pros and cons of this type of lending. The criticisms of microfinance may have some validity in regards to its effectiveness, but if the entire process is looked at as an entire entity, the potential that that microfinance provides is far greater than what the critics of this system seem to picture.

As with any type of industry, there will always be a few that attempt to take advantage of the system. Since microfinance generally works with the poorest of the poor, the idea of taking advantage of these individuals who are already struggling to survive is ethically shocking. Yet there are many financial institutions, non-profit organizations, and private investors which work to avoid indebtedness, offer financial training, and create educational opportunities.

And for most microfinance institutions, the vast majority of recipients tend to be women. Most programs offer women 9 out of every 10 microcredit products that are available.

Here’s how the microfinance process works.

Step #1: The Trust Group

A trust group is usually the first opportunity for individuals to access some form of formal credit when they have received any type of credit before. In a trust group, the members of the group will co-guarantee the loans that are offered to one another. This helps to eliminate the need for any collateral to be offered for a product.

Trust Groups are able to select their own members. This is why women are generally selected for microcredit. Within their communities, the people who are typically selected are seen as the most responsible and trustworthy. This structure creates an overall repayment rate that is often above 90%, with some institutions seeing repayment rates in the 98-99% range.

The typical initial loan that is offered is usually $100 or less. Then each accepted member who has received a new loan is pooled into a “group” of loans that will be repaying their debts together. This way, if for some reason a payment might be missed, it is not uncommon for the community to chip-in and support the loan that cannot make a payment because the group is repaying together.

Even loan officers can help struggling microloans be able to stay current.

In some ways, it’s a form of peer pressure that helps to ensure all loan repayments are made. It also means that the group of loans can come together to help make a big difference.

Then, as the repayment process continues over time, recipients of a microloan begin to develop a formal credit record that would not be obtained otherwise. This creates a future opportunity to obtain a larger loan if needed, pay a lower interest rate, and experience other benefits which come when there is a strong credit score.

Step #2: The Savings Process

Although many people see people in abject poverty as being barely able to survive, many of these individuals have been saving what they can through an informal process. Some bury their savings in the backyard. Others hide it with trusted family, neighbors, or business associates. So it isn’t that people aren’t saving if they live in poverty. They just aren’t putting their money somewhere that it can actually grow in value.

Microfinance changes this opportunity. Instead of burying their savings in the ground, microfinance works by helping people put their money into savings accounts that can earn interest. Many microloans won’t be offered, in fact, unless an individual agrees to put a small amount into a savings account on a regular basis.

This savings process helps individuals avoid returning to abject poverty because of an unexpected expense. It also creates strength within their business, allows for home upgrades, and even more consistent schooling opportunities for their children.

The savings may not add up to a lot from a developed world standpoint, but when you’re living on $1.25 per day or less, being able to save a few dollars is a massive accomplishment that deserves to be recognized. Microfinance encourages that recognition.

Step #3: Insurance Products

Unexpected circumstances created a constant threat for a return to poverty. One bad growing season can be enough to devastate a family’s finances for years to come. Add in a health emergency and you’re almost guaranteed to have that family return to poverty – even with an extensive savings account in place.

For this reason, most microfinance products include insurance products that are provided by the institution or through a micro-insurance subsidiary. This helps to protect microfinance clients from personal or economic issues that would normally devastate their finances.

Numerous micro-insurance products are offered, from life insurance to weather-index crop insurance, with some institutions even offering basic policies for free – paid for by the interest on the microloan that was offered.

This creates financial stability over a long-term basis, reduces the stress triggers that poverty provides, and ultimately builds the foundation that many households need to stay out of poverty for good.

Step #4: Training Opportunities.

Many people, when they first encounter microfinance, may see it as an industry that says, “Hey! You’re poor. Here’s some cash so that you can get back on your feet.”

Unfortunately, there are some lenders which have done just that. This is how indebtedness occurs. Because there is no promotion of skill betterment, the loans become another way to pay bills when money runs short.

The best microfinance institutions use training as part of the microloan process. Education in financial matters, vocational skill development, and even basic literacy become part of the loan process. Many of the women who are looking for a first-time loan don’t know how to read or write, much less be able to properly budget for a 5-year financial plan. By enabling everyone to increase their knowledge in these areas, they have more tools available to them so that they can create their own success.

Training may also include areas of health, such as HIV/AIDS prevention, family planning ideas, or even how to properly handle domestic violence. Whatever will help that person’s quality of life is looked at as a potential training opportunity.

Step #5: Ongoing Partnerships

The problem of poverty is certainly complex. When there is an insistence on complete transparency through the lending process, results tend to occur. New potential borrowers need to be approached with caution and judiciousness in order for the best possible results to be able to form. It also isn’t good enough for microfinance to only focus on the high income earners as a way to boost poverty removal stats.

Only when the poorest of the poor are enable to create a better life for themselves will poverty have a chance to be finally defeated. The goal of microfinance should be to eliminate the need for the industry one day instead of seeking long-term profit margins. So to encourage this growth process, many institutions have started taking a radical approach.

When borrowers are successful in repaying a loan and saving money, part of the investment they are able to make is in the future of the lending agency that extended a loan to them.

Some institutions, like Grameen Bank, have a 90% ownership stake that features former borrowers, current savers, and those who have benefitted from their microfinance products. This allows the institutions to target those who need the most help, reinvesting the interest that the group has paid into more loans, more interest opportunities to collect, and more investors to bring into the fold.

Then the cycle repeats itself.

Step #6: Finding New Capital

In the past, capital for microfinance typically came from grants. Most were government grants, but some foreign investors would also supply grants as part of a charitable donation or similar service. That helped to get the industry started in the 1970s.

As those involved with microfinance realized just how positive the results could be and how much demand there was for microcredit, grants would not be able to provide enough funding. That’s when the industry shifted toward a more traditional approach. Private investors were invited to come on-board to fund microloans. That has now even shifted to the selling of private bonds to raise capital.

There are a number of crowdfunding agencies which also have looked at microfinance as a way to provide individual investors with a return – or at least an opportunity to help someone who could benefit from microcredit. Kiva is one of the better known platforms that provides this service, but Babyloan, Zidisha, Veecus, United Prosperity, Vittana, and several others are alos making a difference in the world of microfinance.

What Microfinance Is Not By Definition

In the past few years, several traditional banking institutions have begun to open up their own microfinance divisions. This includes companies like CitiGroup, General Electric, and Barclay’s. This trend was started by a Mexican bank named Compartamos Banco. All four of these banks are publicly traded companies.

This means their goal in providing microfinance products is to create a for-profit scenario for their shareholders. It is a very different approach from the original non-governmental organization [NGO] approach that started the microfinance movement.

The argument is this: for-profit microfinance lending works against what the original purpose of this type of lending was meant to do. For many, the goal of microfinance was to help those in poverty above any other purpose. By being a publicly traded company focused on profit, helping the poor naturally becomes a second-best option – if that.

Yet the for-profit companies argue that by making a profit, they can extend the reach of their microcredit and therefore help more of those who are in poverty. What’s the difference? You won’t find those who are just coming out of poverty being able to invest into shares of these publicly traded banks like they are with the NGO microfinance lenders.

When institutions can find new capital, then they can provide more microcredit opportunities. When that happens, then the cycle of how microfinance works starts over from step one, with the selection of another member joining the Trust Group to receive a guaranteed microloan without the need for any collateral.

Does Microfinance Actually Make a Difference?

As with any banking product, you will find people in Trust Groups who cannot or will not repay their loans. This added debt might make some individuals become trapped even deeper into poverty. It’s always a possibility.

But what microfinance does do is offer a different option. Local lenders, what we’d call “loan sharks,” were already offering loans to these individuals – and at much higher rates. This offers a financially viable alternative that would normally not be present for individuals in need.

Because microfinance works to provide small loans and credit to the poorest of the poor in the developing world, either through for-profit banks or NGOs, it gives people access to help that they normally would not have. The goal is to work with those who are the most trustworthy, willing to put in a hard day’s work, in order to raise their household out of poverty.

Is it possible that microfinance could put people further into debt? Sure. What we do know is that microfinance does work to help people and that may one day change the world.

Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.