What is microfinance?

I’m on “sabbatical” until early October, while I’m away I’m reposting previous articles that readers may have missed.

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While most donors might not be familiar with the term Microfinance, they probably use a type of microfinance called – credit cards. Perhaps the biggest difference between credit cards and microloans – the type of assistance provided by organizations such as Kiva – is that credit cards are a rolling form of credit, whereas microloans have to be applied for individually each time they’re needed.

The realities of microfinance

There’s a lot of hype about the success and impact of microfinance, however much of it is not backed up with research or data – see GiveWell’s post. To see through this hype and evaluate the potential impact and problems of microfinance just think back to a couple of years ago when credit cards/microfinance were readily accessible. What was the impact?

Common microfinance questions

Does easy access to microloans/credit cards solve some problems? Yes
Access to loans provides people with the ability to invest in small businesses or other items that improve their daily lives and then pay back the expense over time. It also provides a safety net if something unexpected and terrible happens.

Does easy access to microloans/credit cards solve all problems? No
While access to credit did help some people improve their lives there is no proof that easy access to credit solves the variety of social problems it claims to solve. Think of your own country, which social problems were improved with easy access to credit and which were not affected?

Does easy access to mircroloans/credit cards create problems? Yes
Although advertised as ways to help people start small businesses, microloans can be used just as we use credit cards, to pay for events such as cultural celebrations, weddings, or funerals; to buy things we could not afford otherwise; or to buy things that are not essential. For some people this could build up a debt so large that it may be difficult or impossible to pay back, especially if they lose their job or face some other financial crisis. As with credit cards people may use one microloan to pay off another microloan, digging themselves even further into debt or incurring even higher interest rates.

Does your money go directly to the person? No
Just as with credit cards, you should always read the fine print. Most nonprofits offering microfinance do not administer the loan directly but instead use intermediaries called Microfinance Institutions (MFI). The microfinance institution makes the loan from a pool of money provided by the nonprofit. Often the loan is made before it is advertised on the nonprofit’s website.

Are the loans interest free? No
Although the nonprofit you fund may not charge interest, MFIs generally charge interest to cover their operational expenses. The amount charged varies but can be as high as 30%. Also you cannot assume that the nonprofit does not charge interest, examine the financial statement to see if interest from microloans is a source of revenue.

Are all small businesses successful? No
In the US 30% of small businesses may actually lose money over the lifetime of the business. There’s no reason to assume that small businesses in developing countries fair any better. When I traveled through the tsunami affected areas in Thailand at the four year anniversary to determine which projects succeeded and which failed, I spoke with a man whose village had received aid from a charity supporting small business creation. I asked him if the project had been a success, he answered that it depended on the person. Those people with a natural aptitude for business did well, those without it failed.

Do people default on microloans? Yes
Just as people default on credit cards people also default on microloans. If we assume that 30% of businesses fail to make a profit then we could potentially assume a 30% default rate on loans used to start small businesses. However, most charities claim a 95% or better repayment rate, the actual default rate vs. repayment is unknown- see GiveWell’s post. One of the reasons for this is the need by the MFI to keep it’s rating, which is primarily based on repayment rates. To maintain their good ratings MFI’s may cover the defaulted loans themselves, raising their interest rates on all loans to cover the costs. There are also stories emerging of MFIs intimidating loan recipients or confiscating their property in order to recover their losses. Even though you would be OK with the person defaulting on your loan, the MFI may not be.

Is microfinance a good idea?
Just as credit cards serve a purpose, so do microloans. However microloans are just one way to help people get the money they need to start a business or provide a safety net when life goes bad, it should not be the only solution offered. Just as you use other financial services such as savings accounts or insurance plans as a safety net, these services are also beneficial to people in developing countries and should be offered as part of a larger set of financial services. Just as you are able to choose the financial services that best meet your needs, people in developing countries need the same variety of choices so that they can pick the services that meet their needs.

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Other Resources:

David Roodman’s Microfinance Open Book Blog – a great resource for information on microfinance, and the person often cited in other microfinance posts.

GiveWell’s series on microfinance – a great series of posts looking at microfinance research as well as information on charity websites regarding their microfinance programs.

Good Practice Guidelines for Funders of Microfinance A series of guidelines that donors should consider when funding microfinance programs