Microcredit is also known as “microlending” or “microloan.” involves an extremely small loan given to an individual to help them become self-employed or grow a small business.
Microcredit is good for lenders too. Although the risk of the borrower defaulting on the loan is relatively high, this is accounted for through higher interest rates, especially for high-risk borrowers.
This means business owners with poor creditworthiness can still access the funds they need, but at interest rates that mean, it is worthwhile for investors to lend to them — a mutually beneficial scenario for all involved parties.
How Microcredit Works
Microlending organizations facilitate small business loans from individuals to small businesses and new startups.
The concept of microcredit was built on the idea that skilled people in underdeveloped countries, who live outside of traditional banking and monetary systems could gain entry into an economy through the assistance of a small loan. The people to whom such microcredit is offered may live in barter systems where no actual currency is exchanged.
Modern microcredit is typically attributed to the Grameen Bank model, developed by economist Muhammad Yunus. This system started in Bangladesh in 1976, with a group of women borrowing $27 to finance the group’s own small businesses. The women repaid the loan and were able to sustain the business.
The women in Bangladesh who received microcredit did not have money to purchase the materials they needed to make the bamboo stools that they would, in turn, sell — and at the same time, each individual borrower would be too risky to lend to on their own. By borrowing as a group, the initial financing gave them the resources to begin production, with an understanding that the loan would be paid over time as they brought in revenue.
The structure of microcredit arrangements frequently differs from traditional banking, wherein collateral may be required or other terms established to guarantee repayment. There might not be a written agreement at all.
In some instances, the microcredit was guaranteed by an agreement with the members of the borrower’s community, who would be expected to compel the borrower to work toward repaying the debt. As borrowers successfully pay off their microcredits, they may become eligible for loans of larger and larger
amounts.
Each potential borrower receives a credit rating. The lending platform calculates this using their real-world credit history, any assets they own and their commitment to repay any previous microfinance they borrowed through the same site.
The result is a rating system that identifies high-risk applicants and those most likely to repay in full and on time.
However, because there is less security in microfinance investing than there is in traditional bank loans, the interest rates paid by the borrower tend to be higher.
For example, an interest rate of 6% is typical for the cheapest microfinance loans, rising to more than 30% for borrowers with the worst credit rating.
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