WHAT IS MICROFINANCE?
Microfinance is a type of banking service offered to people who normally have no access to finance. People excluded from regular banking services are farmers, the poor, and often women. Microfinance has sometimes been called ‚financial inclusion.‘ However, this is a contentious term because there is still much debate about how accessible microfinance is for people.
Microfinance is mainly associated with micro lending. However, microfinance institutions (MFIs) also provide other services like financial and business education, and micro insurance.
HOW TO RECEIVE A MICRO LOAN
Applying for a micro loan is far easier than getting a traditional bank loan. This is because MFIs, unlike banks, do not expect the borrower to have collateral. Collateral refers to property or any other asset that the borrower may offset against the loan. MFIs instead focus on helping their clients succeed as entrepreneurs.
The first step in applying for a micro loan is to contact the nearest MFI branch. These branches usually exist across a given country. For example, BRAC Uganda has 89 branches in 39 different districts in Uganda.
Because borrowers do not need collateral to apply for a loan, MFIs often attach their loans with other conditions. Many MFIs provide financial and business education to clients before lending any money. This training allows MFIs to be more confident that the borrower will repay their loan.
As part of their financial and business education, clients learn how to budget; how savings accounts work; and how to manage debt, to name just a few lessons.
REPAYING A MICRO LOAN
The next step for customers is to invest the money in their small businesses or other entrepreneurial ventures. So for example, a borrower might buy new equipment like a sewing machine to increase profits. This makes it easier to repay the loan in the future.
Exactly when the borrower repays the loan depends on the repayment schedule agreed with the micro lender, as well as the borrower’s ability to repay. First time borrowers normally receive less money and have a shorter period of time to repay the loan. They may also have to pay back more interest on the loan. Over time, micro lenders can make the arrangement more flexible. They are more likely to do this if clients prove that they can handle the loans capably, and especially if they show entrepreneurial success.
BORROWING AS AN INDIVIDUAL
Many people receive micro loans as individual customers. These customers may have to set aside some of their income in a savings account as insurance. This means that were the individual unable to repay the loan, the lender is entitled to take this money from the account. If the borrower repays the loan successfully, then they are of course allowed full control of the account.
BORROWING AS A GROUP
Other customers choose to apply for a loan by getting together in a group. This system works through a form of peer pressure to make sure every individual repays their share of the loan.
Borrowing as a group has some advantages and disadvantages. On the positive side, working together is a way of pooling risk. This means that the likelihood of defaulting on a loan is much lower. To default on a loan means being completely unable to pay any of the loan back within the agreed time period. The risk of defaulting is lower because at least some members of the group should be able to repay the loan, rather than the cost of repayment falling on one individual.
On the other hand, working as a group often leads to lower rewards for each person. Micro lenders might give smaller loans to groups because clients doubt whether their partners are able to repay their debts. Working in groups also creates the problem of free riding. This is when certain people work less hard because they expect others in the group to work for them. In turn, hardworking individuals may reduce their contributions because they suspect their partners may be living off of their work.