What is Microlending?
Microlending programs are a type of peer-to-peer financing for small businesses and new startups. As the name suggests, microfinance is lending on a microscopic scale, with business owners receiving funds from individuals instead of from a bank or credit union.
A microloan program can have multiple benefits for small business owners, ranging from easier access to funds, to larger loans that aggregate funds from more than one microlender.
Microfinance is good for the 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.
What is microcredit?
Microcredit serves as an alternative to conventional lending and is typically used by new businesses and small firms that would otherwise find it difficult to get approval for a loan.
The kinds of organizations that borrow using microcredit fall into two broad categories:
- Small businesses in the developing world where traditional borrowing is not available to low-income companies
- New companies and small firms in developed countries who can't get small loans due to bad credit or similar circumstances
Some microborrowers turn to peer-to-peer financing because they only need a minimal amount of funds, and this is less than the minimum amount available via a bank loan.
Microlending can be driven by the individual as much as the organization. Borrowers will often include a personal appeal, profile, or biography to entice investors to choose them.
Borrowers can receive 100% of their required funding from a single investor or aggregated from many, unlocking a larger amount of money.
However, this also runs the risk that the loan will attract bids from investors that total less than 100%, which usually means the microlending platform rejects the whole application.
If the application reaches 100% in investor bids, then the microloan will be paid out to the small business, which is then obligated to repay the loan with interest according to a repayment schedule.
How does microlending work?
Microlending organizations facilitate small business loans from individuals to small businesses and new startups.
Investors who want to offer microloans for startup businesses choose their preferred online platform and look for microlending opportunities on the website.
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.
As is the case with other forms of credit, business owners can access low-interest rates by appearing to be a safer prospect to microfinance investors in several ways:
- Improving their consumer credit rating
- Holding assets (e.g. a house) that can be sold to repay the loan if necessary
- Meeting repayments regularly to build up trust with the microlending site
All of these options show good stewardship of money and in particular, effective management of debt.
Why get a microloan?
You should carefully consider any applications for business finance, weighing up the reasons for taking the loan and the needs of the business against the risks and costs associated with doing so.
On the one hand, taking a microloan means exposing your business to the risks of debt, as well as an inflexible repayment schedule that can create the threat of insolvency if you miss one or more instalments.
But the flip side of this is access to early-stage financing to help your new company grow and become more established. If you are confident of this growth, you might also feel more certain of being able to repay the loan relatively easily.
For many business owners, the reasons to get a microloan start with availability. If traditional financing is not available to you because the banks don't consider you a good enough credit risk, microfunding can be a viable alternative.
However, there are other reasons why to get a microloan. These include:
- Smaller loans that are short term and below the minimums offered by banks
- Convenience of an online platform where you can build up a proven history of proper debt management
- Ability to reach out to investors by providing a personal statement or other persuasive materials
You might consider microfunding to be the best option, even though traditional lenders would be available to you too.
And although the interest rates might be slightly higher, the difference can be small for borrowers with a good credit rating, so some business owners prefer peer lending as a way to work with individual investors rather than the banks and other financial institutions.
What are the advantages of microlending?
Often the benefits of a particular type of credit are biased in favor of the creditor or the lender, but not both. For example, bad credit loans often have very high interest rates, but debtors may feel they have no alternative option.
Microlending has benefits for investors and business owners alike:
Accessibility is a major benefit of microfinancing. Investors can support small businesses and new startups in their own country and elsewhere in the world.
For business owners, microloans are a way to access funds even with no credit history or a bad credit score. The interest rates may be higher to reflect the higher level of risk, but that can be mitigated by entrepreneurs who can show themselves to be more reliable.
One reason why the business might not have a good credit history is simply because it does not have any history at all. For entirely new small businesses, accessing conventional lending could be difficult to impossible due to a lack of proven trading success.
Microloans are different. They cater to this demand without necessarily needing years of successful trading - therefore giving new startups easier access to small amounts of money at a moment in their development when they are most in need of finance.
Microfunding has some good options in terms of scalability. Again, these are mutually beneficial, such as the option for investors to fully fund projects or to put as little money in as they wish.
Because of this same scalability, business owners can request as little or as much money as they need. While it's important always to keep in mind the interest rates payable and whether or not the business can meet the repayments, in principle the risk of a larger loan can be shared by more investors, so no one person is adversely affected if the debtor defaults.
What are the disadvantages of microlending?
Despite the advantages of microlending listed above, there are inevitable costs and risks involved, which borrowers must be careful to take into account.
For business owners there are numerous disadvantages of microlending:
The big disadvantage of microfinance is the amount of interest payable on the loan. Even the applicants with the best credit ratings are subject to interest rates higher than the banks normally charge on conventional loans.
However, it's important to remember that these higher interest rates are part of what makes microlending appealing to investors. This, in turn, ensures that funding is available to bad credit businesses and new startups with no proven track record of managing their finances.
Some microlending platforms factor personal assets like the borrower's house or car into their calculated credit rating. The clear implication is that if the borrower defaults on their microloan, the lender could pursue them with a claim against their personal assets.
For borrowers, this can be off-putting, as it means personal possessions, including the family home, can be linked directly with the success or failure of a new business venture. Fail in business, and you not only lose the time and money you have invested but may also lose your home if you have to sell it to repay your microloan.
All or Nothing
Finally, as mentioned above, it's usual for microfinance to be subject to an all or nothing rule. That means unless the listing gets bids totaling 100% of the requested loan amount, the microlending site does not pay partial funding even if investors made smaller bids.
This is a common feature on peer-to-peer finance platforms, including those aimed at bringing new innovations to market. However, it does give borrowers more incentive to make their business opportunity sound as appealing as possible and set a realistic goal for fundraising, so that investors have every reason to support it with bids of 100% or more.