What is Microfinance?

Microfinance is an alternative to the traditional banking system. It is designed to provide financial services to client groups that are underserved or overlooked by traditional financial services providers. These can be individuals or businesses although some microfinance providers may specialise in either personal or business microfinance services.

While commercial lenders can offer microfinance services, much of the microfinance sector is run by not-for-profit entities. In the UK, for example, a significant percentage of the microfinance services on offer are run by credit unions. Globally, microfinancing options are often run by charities and non-governmental organisations (NGOs).

Understanding microfinance

At present, there is no official microfinance definition. There are, however, certain defining features of microfinance that generally make it recognisable. Probably the most obvious of these is that it is only used for small amounts of money. As a result, it’s suitable for those on low incomes and/or those with poor non-existent credit records. This means that it can be accessed by the economically disadvantaged.

Microfinance is often provided on a non-commercial basis. This generally means that products (e.g. loans) have to cover their costs but little or nothing more than that. When profits are made, they are often low and intended for reinvestment in the service. These microfinance providers are likely to be driven by social/environmental goals.

That said, there are microfinance products which are highly commercial and usually very expensive. For example, credit-building products often meet the criteria for microfinance as do “payday loans” and the equivalents for business.

In the UK (and some other markets), microfinancing providers often leverage technology. For example, they may have their own mobile apps. This is, however, not universal, even in the UK. Some microfinancing providers actually use a very traditional approach. For example, smaller credit unions may use paper bank books. In some cases, this may be a deliberate choice due to the market they serve.

What is a microfinance loan?

As the name suggests microfinance loans are loans issued for small amounts. For clarity, what this means in practice will depend on the current standards in the specific market. Despite being relatively low in value, they may require more administrative effort to set up. This is because microfinance loans tend to be highly customised to each client.

For example, instead of looking for collateral and/or guarantors, microfinance providers will look very closely at the potential borrower’s situation. They will use this analysis to determine not just how much they can reasonably lend but also how they lend it. In particular, it will often guide their decision on how to manage repayments.

Advantages of microfinance

From the perspective of a potential client, the main advantage of microfinance is that it’s available. Other benefits include flexibility and a very strong emphasis on serving a particular target market. From a provider’s perspective, the benefits of microfinance depend on the provider’s goals. 

For commercial lenders, the main benefit of supporting microfinancing is that it helps them to reach new client bases. Depending on their business model, they may aim to generate profit in the short term or build these clients into higher-value customers (or a combination of both). Another benefit is that adopting microfinancing can help to diversify a provider’s income stream.

For non-commercial providers, the benefits of microfinancing tend to relate to the achievement of social and/or environmental goals. Essentially, non-commercial microfinance is often used as a tool to help the economically disadvantaged to help themselves.

Disadvantages of microfinance

From a potential borrower’s perspective, the main disadvantage of microfinance is that it’s micro. For example, microloans are highly unlikely to be enough for significant business investment. They may offer more flexibility than traditional business loans. Modern, flexible business loans, however, often work in a similar way to microloans but provide more funds.

From a commercial provider’s perspective, the main disadvantage of microfinance is that its short-term profits do not necessarily justify the amount of work involved. With some products (e.g. loans), offering microfinance may increase the provider’s risk. 

For non-commercial lenders, the main disadvantage of microfinance is that it can require a lot of resources and effort to manage effectively. There is also no guarantee that it will achieve the desired goals.

Microfinance schemes

Three of the best-known microfinancing schemes are Kiva, the No Fixed Address initiative and the credit union network.

Kiva is essentially a peer-to-peer lending platform specialising in microloans to entrepreneurs and students. The organisation itself operates on a non-profit basis. Its mission is driven by the belief that lifting one can lift many.

As the name suggests, the No Fixed Address initiative aims to offer basic banking services to people without a fixed address. Giving these people access to bank accounts enables them to access opportunities they would otherwise have been denied. In particular, it enables them to work for employers who pay by bank transfer rather than cash payments.

Credit unions are also an example of microfinancing schemes. They are all very small-scale financial providers offering a limited range of financial services to a restricted client base. In the UK, credit unions often serve a particular geographic area. They may, however, choose other criteria for their client base, such as a profession or vocation.

30/10/23: While we want to help as much as we can, the information found here is provided solely for informational purposes and should not be considered financial or legal advice. To the extent permitted by law, Funding Circle does not accept any liability for any loss or damage which may arise directly or indirectly from the use of, or reliance on, the information contained here. If you have any questions, please speak to your professional adviser or seek independent legal advice.