Microloan 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 where business owners receive funds from individuals rather than from a bank or credit union.
A microloan program can have many benefits for small business owners, ranging from easier access to funds to larger loans that pool funds from more than one microlender.
Microfinance is also good for lenders. Although the risk of a borrower defaulting on a loan is relatively high, this is due to higher interest rates, especially for high-risk borrowers.
This means that business owners with poor credit can still access the funds they need, but at interest rates that mean it's worth it for investors to lend - a win-win scenario for all parties involved.
What is microcredit?
Microcredit serves as an alternative to conventional lending and is commonly used by new businesses and small firms that would otherwise have difficulty getting approved for a loan.
The types of organizations that take out loans using microcredit are divided into two large categories:
- Small businesses in developing countries where traditional loans are not available to low-income companies
- New companies and small firms in developed countries that cannot obtain small loans due to bad credit history or similar circumstances.
Some microborrowers turn to peer-to-peer financing because they need a minimum amount of funds, which is less than the minimum amount available through a bank loan.
Microcredit can be carried out by both individuals and organizations. Borrowers often include a personal statement, profile or biography to entice investors to choose them.
Borrowers can get 100% of the funding they need from one investor or a combination of many, opening up a larger amount of money.
However, this also comes with the risk that the loan will attract applications from investors whose total amount is less than 100%, which usually means that the microlending platform will reject the entire application.
If the application reaches 100% in investor applications, the microloan will be paid to the small business, which is then required to repay the loan with interest according to the repayment schedule.
How does microcredit work?
Microcredit organizations provide small business loans from individuals to small businesses and new start-ups.
Investors who want to offer microloans to start-up companies select their preferred online platform and search for microloan opportunities on the website.
Each potential borrower receives a credit rating. The lending platform calculates this using their actual 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 their debt in full and on time.
However, because microfinance investments are less secure than 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 ratings.
As with other forms of credit, business owners can access low interest rates as they appear safer for microfinance investors in several ways:
- Improving consumer credit rating
- Having assets (such as a home) that can be sold to pay off a loan if necessary.
- Regular payouts to build trust in the microlending site
All of these options demonstrate good money management and, in particular, effective debt management.
Why take a microloan?
You should carefully consider any application for business finance, weighing the reasons for taking out the loan and the needs of the business against the risks and costs associated with it.
On the one hand, taking out a microloan means exposing your business to debt risks, as well as an inflexible repayment schedule that can pose the risk of insolvency if you miss one or more payments.
But the downside to this is access to early-stage funding to help your new company grow and strengthen. If you're confident in that growth, you can also be more confident that you'll be able to repay the loan with relative ease.
For many business owners, the reasons to get a microloan start with affordability. If traditional financing is not available to you because banks don't consider you risky enough, microfinance may be a viable alternative.
However, there are other reasons why you should take out a microloan. This includes:
- Smaller loans that are short-term and below the minimums offered by banks
- The convenience of an online platform where you can create a proven history of good debt management
- Opportunity to reach investors by providing a personal statement or other compelling materials
You may find microfinance a better option, even if traditional lenders are also available to you.
And while interest rates may be slightly higher, the difference may be small for borrowers with good credit scores, which is why some business owners prefer peer-to-peer lending as a way to work with individual investors rather than banks and other financial institutions.
What are the advantages of microcredit?
Often the benefits of a particular type of loan are skewed in favor of the lender or the creditor, but not both. For example, bad credit loans often have very high interest rates, but debtors may feel like they have no other option.
Microcredit has benefits for both investors and business owners:
Available
Accessibility is the main advantage of microfinance. Investors can support small businesses and new start-ups in their own country and in other countries around the world.
For business owners, microloans are a way to access funds even if you have no credit history or bad credit. Interest rates may be higher to reflect the higher level of risk, but this may be mitigated by entrepreneurs who can show themselves to be more reliable.
Early
One reason a business may not have a good credit history is simply because it has no history at all. For brand new small businesses, access to conventional lending may be difficult or impossible due to a lack of proven trading success.
Microloans are different. They meet this demand without necessarily needing years of successful trading, thereby giving new startups easier access to small amounts of money at a time in their development when they most need funding.
Scalability
Microfinance has some good options in terms of scalability. Again, this is mutually beneficial, for example investors can fully fund projects or invest as little money as possible.
Because of this same scalability, business owners can request as much money as they need. While it is important to always be mindful of the interest rates payable and whether the business can repay the debt, in principle, the risk of a large loan can be shared among a large number of investors, so no one person suffers if the debtor defaults.
What are the disadvantages of microcredit?
Despite the benefits of microcredit listed above, it is associated with inevitable costs and risks that borrowers must carefully consider.
For business owners, there are numerous disadvantages of microcredit:
Interest rates
The big disadvantage of microfinance is the amount of interest payable on the loan. Even for applicants with the best credit scores, interest rates are higher than banks typically charge on conventional loans.
However, it is important to remember that these higher interest rates are part of what makes microcredit attractive to investors. This, in turn, ensures that financing is available to businesses with poor credit and new startups that do not have a proven track record of managing their finances.
Personal assets
Some microlending platforms factor personal assets, such as a borrower's home or car, into their calculated credit score. The clear implication is that if the borrower defaults on the microloan, the lender can pursue him with a claim against his personal assets.
This can be frustrating for borrowers because it means that personal assets, including the family home, may be directly linked to the success or failure of the new business venture. Fail in business and you will not only lose the time and money you invested, but you could also lose your home if you have to sell it to pay off the microloan.
All or nothing
Finally, as mentioned above, microfinance generally follows an all-or-nothing rule. This means that if a listing does not receive applications totaling 100% of the requested loan amount, the microlending site will not pay out partial funding, even if investors have bid less.
This is a common feature of peer-to-peer funding platforms, including those aimed at bringing innovation to market. However, it does give borrowers more incentive to make their business opportunity look as attractive as possible and set realistic fundraising goals so that investors have every reason to back it with 100% or more of the offers.
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