How Microlending Helps Small Businesses Grow
If you have applied for a business loan recently, you understand how difficult it is to qualify for a business loan. The truth is that most lenders aren’t willing to risk their profits by giving a loan to entrepreneurs who don’t meet certain requirements.
Lender stay in business by only lending to borrowers who demonstrate a strong likelihood to pay back the loan based on certain criteria found in their financial information and credit history.
To alleviate this problem, microlending serves as a way to provide loans to those who would not otherwise access to loans.
Compared to traditional lending, microlenders take on the risk of offering loans without collateral. Borrowers can range from indigents to entrepreneurs with poor credit history.
What Is Microlending?
Microlending reflects the increasing growth of the peer-based economy that helps entrepreneurs gain access to capital.
Microloans are small loans issued by individuals instead of traditional lenders such as banks. Lenders can contribute to a single loan or spread out their contribution to cover a portion of several loans.
Lenders can extend a loan to borrowers who either have poor credit history with traditional sources, or borrowers who do not have access to traditional financing due to their geographic location.
Microloans are ideal for two major scenarios: to help individuals in serve two main purposes. First, microloans help less fortunate individuals in economically underdeveloped countries start small businesses. Second, microlending helps entrepreneurs who do not have access to traditional loans due to poor credit, or other financial reasons that categorize them as ‘high-risk’ to traditional lenders.
Assist Borrowers In Economically Underdeveloped Countries
Microlending is used to help borrowers with in economically underdeveloped countries who do not have access to traditional methods of financing.
Similar to the process associated with traditional loans, borrowers must provide the purpose for the loan, and a business plan detailing its operations. The borrower must provide personal information as well as a bio for consideration.
Help Entrepreneurs With Bad Credit
The second purpose is to lend to entrepreneurs who either have poor credit or seek small loans below the bank minimum requirements.
How Does Microlending Work?
Multiple lenders can fund either a single microloan or portfolio of microloans in order to minimize the financial impact and diversify the level of risk in the event of default.
Once the loan has matured, lenders get interest on their loan and repayment of the principal. Since the risk of default is imminent, the high interest rates make microlending an intriguing risk for some investors.
How Do Microlending Companies Make Money?
Microlending companies generally earn a profit by charging fees to set up and maintain loans. These fees are usually added to the borrower’s interest rate, which is one of the many reasons that interest rates are so high for microloans. Microloans are much riskier than other loans since there is no collateral in the event of default. The high rates ensure that all parties lend and borrow
The Pros And Cons Of Microlending
There are many attributes that make microlending a positive venture for lenders and borrowers alike, such as economic growth, opportunities for entrepreneurs, and a high return on investment for lenders.
Positive Economic Growth Around The World
Microlending has steadily increased in popularity due to the immediate gratification and sense of connection it brings to borrowers and lenders. Lenders who can afford to lend out their savings get a nice return on their investment while knowing that they are helping borrowers reach their goals. Borrowers get access to funding that they would not have received from traditional lenders. When managed correctly, microlending is a win-win situation for all parties.
Lenders Earn High Interest Rates
Because interest rates are high, lenders stand to benefit greatly if they exercise discretion in their lending. Lenders can select which loans they want to fund, and they can also request more information about the borrower before making a commitment.
Share The Risk With Other Lenders
Because of the uncertainty surrounding borrowers, lenders often invest a small amount for each microloan, but still fund portfolios containing multiple microloans.
As a result, borrowers may discover that their loan actually belongs to several lenders to equal the total loan amount. Spreading the risk across multiple loans gives lenders peace of mind that the portfolios will be safe even if a couple of the loans default.
Because just one microloan carries a huge risk, lenders often allocate their investment across a portfolio of several microloans. Therefore, most borrowers will discover that more than one lender will fund their loans. Allocating the risk across various loans will protect lenders against losing their portfolio if a couple of their loans default.
Understand the Risk And Plan Accordingly
Traditional lenders ensure profits by lending to borrowers who demonstrate a strong likelihood to pay back the loan. While the same is not true for microlenders, they can still take steps to minimize the risk of default.
Borrowers are rated based on financial data such as their credit history, background check results, and repayment history for previous microloans, if applicable.
Remember, the lender gets to decide whether to fund the loan, whether it be for personal reasons or doubts about the borrower’s ability to pay back the loan or carry out the business plan. In certain cases, loans may be inadequately funded due to the lack of lenders willing to make a contribution.
While microlending can help entrepreneurs get loans and lenders earn high interest rates on their savings, there are some risks and downsides that must be seriously considered before entering into an agreement.
High Risk In Event of Default
Why is microlending so risky? Unlike their traditional counterparts, micro loans are usually not supported by collateral. While lenders run a high risk of recovering little to nothing in the event of loan default, lenders are made aware of the risks before they lend money. Lenders face a dilemma, but they know the risk going in. Remember, if the lender does is suspicious of the borrower’s intentions, the lender can elect to not fund that specific loan.
High Interest Rate For Borrowers
While the risk is higher than a traditional loan, it is still better than no loan at all. In addition, it is much better than high rate personal loans with impossible repayment terms. Even the candidates with the best financial history are still offered interest rates higher than traditional loans.
Microlending companies such as Prosper show interest rates ranging from 6% for borrowers with the best credit to 31.9% for borrowers with high risk factors.
If the investor feels that 6% is a safe risk for extending a loan, the loan may give a better return on investment compared to other methods of lending.
Since financial institutions find these borrowers to be high risk, borrowers turn to individual lenders to fund microloans.
The Bottom Line: Microlending Helps Everyone
With microlending increasing in popularity, small businesses will get better opportunities to compete with larger businesses by having access to the same type of loans as their more fortunate peers. Private lenders with enough money in their savings accounts can set the parameters for lending and earn a competitive interest rate while helping entrepreneurs fulfill their dreams.