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Microlending – The Risks and Rewards

What are the risks and benefits of microlending for small businesses

There has been a lot of buzz around the term “microlending” in the last decade or so. What is microlending? And, who is benefiting from this trend? Simply put, microlending is a form of financing that provides small amounts of money to typically very poor fledgling entrepreneurs to encourage self-sufficiency and to end poverty – particularly in developing countries. The funds that they receive through microlending programs are used to start businesses. Over time, they are able to pay back the loans with the ultimate goal being to raise their income status and potentially others who they hire.

While the concept of lending money to small business owners has been around for many thousands of years, modern micro financing originated with the Grameen Bank in Bangladesh in 1983. The bank was founded by Muhammad Yunus who used his own money to provide small loans at low interest rates to the poor in a small town called Jobra. The idea spread globally quickly with hundreds of institutions offering microloans throughout much of the third world. Muhammad Yunus was awarded the Nobel Peace Prize in 2006 for his work with helping the poor through microlending.

Today, microlending has become big business with many for-profit and non-profit companies offering micro financing options to businesses worldwide, including recently the United States. Some microlending companies, such as Kiva, utilize loans from private individuals. Kiva enables anyone to loan money in increments of $25 to entrepreneurs from their database. This provider is particularly proud of their repayment rates on their loans, but individual lenders should always realize that there is the risk of not getting paid back. Many Kiva lenders view microlending as a charitable cause and don’t really concern themselves with whether or not they’ll be repaid.

In the microlending world, lenders seem to prefer to loan money to women, although there are plenty of male recipients of microloans too. This might be to do with the fact that they are able to start smaller businesses and that they seem more reliable, in the eyes of lenders, when it comes to repaying back loans. Whether you’re male or female, there are microloan opportunities available if you can demonstrate that you have a great business idea and the ability to pay back the loan once you get it off the ground.

How Does Microlending Work?

Microlending was initially developed as a more savory alternative to loan sharks who were notorious for taking advantage of their borrowers. Small loans are provided at an affordable cost with the goal of providing a real opportunity to borrowers. The global average interest and fee rate is estimated at 37% with rates as high as 70% in some areas. The high interest rate is typical because of the high transaction cost of traditional microfinance operations relative to the size of the loans that microlenders offer.

Many argue that the high cost of micro lending defeats its purpose as a poverty fighting tool. What an undisputable fact is that borrowers must make at least enough to cover the principal and interest on a loan to ensure that they don’t end up even poorer as a result of accepting the loan.

Microlending in the United States

Before the most recent recession, micro financing was a concept that was for the most part limited to the developing world. However, with the tightening of the credit markets and an increased demand for smaller loans, microlending’s appeal has grown tremendously.

Both Kiva and Muhammad Yunus’ organization Grameen Bank have widened their lending to the United States. And, the economic stimulus bill of 2009 granted $54 million to the Small Business Administration to enable microlenders such as these to help more small business owners. Even cities, such as San Francisco and New York, have joined in the microlending trend by introducing their own microfinancing programs.

With many still dealing with the aftermath of the extended recession, aspiring entrepreneurs have become increasingly interested in working with microlenders. Fewer business owners have the ability to borrow against home equity, obtain credit cards, or qualify for traditional bank loans, yet the need for financing still remains.

As well, most community and national banks don’t grant business loans of less than $50,000 because the profit isn’t there to make them worthwhile to offer. In contrast, most microlending programs in the US offer loans under $35,000 to small businesses with five or fewer employees. The interest rate for microloans in the United States ranges from five to 18 percent which is higher than most bank loans.

While some microlenders are in the business of making money, many have a more distinct mission of trying to alleviate poverty. Besides checking applicant’s credit scores, most microlenders also require loan recipients to take workshops on business plans, marketing, and money management. This education process is part of a bigger picture of helping business owners help themselves as they grow their enterprises.

Overseas, Kiva offers loans up to $3,000, but in the United States, the loans can be as high as $10,000. Over 150 businesses of have been helped by Kiva since the roll out its microlending service in the US. Many of the individuals who offer loans on Kiva actually prefer helping business owners on their own turf as opposed to those in other countries.

Microlending: Risks and Rewards for Borrowers

If you are a small business owner who is in need of funds and have considered microlending, it’s important to carefully weigh the risks and rewards of this type of financing. There are definite pros and cons, and it is certainly not right for everyone.

Microlenders are much more interested in a business owner’s passion and commitment to their business than are traditional banks. If you have a great idea and a well fleshed out business plan, you’re far more likely to get funding from a microlender than from the bank down the street.

Microlenders also weigh their decision much less on an applicant’s credit history. If you’ve been turned down by banks or other lenders, you still may qualify for a microloan if you can effectively demonstrate need and that your business truly has potential.

If you need less than $50,000, you may not be able to find a bank that will be willing to even provide a loan to start or grow your business. Again, working with a microlender can be a good choice when you only need a small amount of cash to achieve your success.

There are definitely risks, though, when it comes to borrowing money from a microlender. The biggest is the higher interest rate. It will take more to pay back the money you borrow from a microlender, and this should be a big consideration. If your interest rate is 18%, it may not be in your best interest to take the funds – particularly if there is any risk that your business will not make enough to cover the principal and the interest. Non-payment on a microloan can hurt your credit just as much as defaulting on a more traditional loan.

Another hindrance to applying for a microloan is the time it takes to get the funds. There are many businesses applying which can cause delays. And, you can expect to have to spend additional time taking either online or in-person classes on a variety of business-related topics before you get your cash.

Still interested? If so, remember to compare a few microlending programs before applying and to carefully read the terms of any microloan you decide to take. Knowing exactly what you’re getting into before you get the cash will ensure that your business stays on track and that you will be able to truly benefit from the funds you’re loaned.

Microlending vs. Peer to Peer Lending

An offshoot of microlending is peer-to-peer (frequently abbreviated to P2P lending) which is the practice of lending money to unrelated individuals without going through a traditional bank or another financial intermediary. Lending occurs on P2P sites using a variety of platform and credit checking tools.

The vast majority of P2P loans are unsecured personal loans, but oftentimes these loans are given to small business owners. Unlike most microloan programs, P2P lending programs are conducted for profit. Interest rates typically are competitive (often below 10%) which is favorable for borrowers, and lenders typically see higher rates of return than on savings accounts or other investments.

Prosper and Lending Club are two of the largest P2P lending platforms with many smaller ones now gaining ground. With low overhead, these service providers can run leaner than almost all financial institutions enabling them to offer inexpensive loans to those with good credit. For business owners with bad credit, P2P lending isn’t typically a strong option. This is when working with a microloan program might be a better choice. Other alternatives include loans from family or friends, angel investment, or revolving lines of credit from American Express® Business Line of Credit, which looks at a variety of factors to determine creditworthiness besides just a credit report.

Microlending: Risks and Rewards for Individual Lenders

Most individual lenders choose to participate in a microlending program because they want to give back in some way. Whether it’s to help a woman launch a handicraft business in a far-reaching Asian village or the desire to support a local community, lenders should be considering microlending as a form of philanthropy as opposed to a way to turn a profit. Doing good is often the only reward in participating in a microlending program.

Many individuals are personally touched by the stories of those they help which motivate them to continue to give. It’s often amazing to realize how such a small amount of money to one person can be life-altering in a positive way to someone else. These stories often are what keep many individuals microlenders wanting to lend again and again.

On the flipside, there are some downsides that are inherent to all types of microfinancing. It’s important to first realize that there is a risk in lending money. Not all borrowers will pay back loans. You should only offer money if you can afford to lose it. Hopefully, you will be paid back in full, but if you don’t, you don’t want it to break your bank!

It’s also necessary to be realistic. Not all borrowers are honest, and some are simply out to make a quick buck on the backs of the kind, generous lenders. There is definitely a shady side to microlending that involves individuals presenting themselves as needy aspiring business owners to simply collect loans for their own use. While most microlending organizations do their best to weed out these less than scrupulous applicants, some do slip through the cracks. And, it can be quite disheartening to find out that you’ve been taken!

Before you decide to become a microlender, it’s important to have a good understanding of how your money will be loaned out and to whom. You’ll want to also find out when you can expect to be paid back and what happens if the borrower can’t or won’t pay back the loan. It’s also a good idea to keep in the back of your mind that you are always taking the chance of not getting paid back.

Whether you’re a business owner looking for funds to launch a business or take it to the next level or are an individual lender hoping to help a business owner with a microloan, there are plenty of options available. These programs are definitely proving that not every lending transaction has to go through a traditional bank and that sometimes a little cash in the hands of an aspiring entrepreneur can go a long way. Joining worthy business owners with socially responsible lenders definitely makes good business sense both locally and worldwide.

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