Microfinance

Microfinance is the delivery of financial services in small amounts – mainly loans but increasingly savings and insurance – to entrepreneurs who typically do not have access to mainstream or traditional financial services. A microfinance institution refers to an organization that delivers small loans to help entrepreneurs create and grow a business.

Most entrepreneurs use personal savings and loans from family or friends to start their businesses. However, even these combined funds may not be enough to start the business. Sometimes it’s just a small amount that can bridge the gap. Entrepreneurs needing more capital look for additional sources of funding. Many lending institutions such as traditional banks require qualifications that new entrepreneurs do not yet have. For example, many banks want to see that a business has been successful for three years, that the applicant has a high credit score or positive credit history, and that there are enough valuable assets (personal collateral or assets in the business) to cover the loan in the event the business fails. As a result, entrepreneurs just starting out often do not qualify for loans at traditional banks. Microfinance has emerged to fill this need for small loans to new entrepreneurs.

By most accounts, microfinance institutions vary significantly in their missions, strategies, and practices. In many countries, the microfinance institutions operate as semi-formal entities. That is, they are usually required to register with the government before operating, but they are not heavily regulated like traditional banks. In practice, the microfinance industry tends to be self-regulated. What this means for entrepreneurs is that it can be quite difficult to compare one microfinance institution to another. Additionally, entrepreneurs may not be aware that some of the microfinance services and products can be misleading and can actually make their financial situation worse.

In seeking appropriate microfinance products and practices, entrepreneurs can first categorize microfinance institutions as either client-centered or institution-centered. 

• Client-centered microfinance organizations see it as their mission to help develop the profitability of the borrower's business, as well as supporting client protection standards even when regulations are not in place. These microfinance institutions are usually run as nonprofits that offer not only financial products and services, but also financial education and business training. These institutions aim to protect their borrowers by helping create loans that are beneficial for the business AND affordable for the business owner. 

• Institution-centered microfinance organizations offer a few basic, high-quality, low-cost services to as many borrowers as possible. These microfinance institutions are usually for-profit and typically do not place borrower protection as a key priority. For example, lending institutions with borrower protection should evaluate your current financial situation to help you avoid borrowing too much or at too high a rate so that you are not struggling to make payments. Institution-centered microfinance lenders may also give their borrowers the impression that by borrowing more money they have a greater opportunity for success in their business, or better financial situation. Often the opposite is true because the cost of the loan goes up as the loan amount increases.

It is very important that entrepreneurs understand and be able to assess the types of microfinance organizations available to them and to develop their finance and business skills before and while taking out microloans to fully understand all the factors of the loan. Entrepreneurs should focus on client-centered microfinance organizations wherever possible.

Not all microloans are good. That is, microfinancing can lead to high rates of interest and debt traps. Microfinance’s interest rates are considerably higher than those of mainstream banks. At the global level, microfinance’s interest rates are about 40 percent. In countries like Mexico and Bolivia, the average is more than 60 percent. 

However, at the same time, the microfinance’s interest rates are far below the interest rates of informal money lenders or “loan sharks,” which can be 70 percent or more. In some countries like China and Vietnam, governments have enforced an interest rate cap on microloans of no more than 30 percent. 

Unfortunately the high interest rates have contributed to small business entrepreneurs having too much debt. In part, this has led to hazardous lending standards, procedures, and practices for borrowers. This is further heightened when entrepreneurs borrow more than they need, or make poor choices when selecting loans with harsh repayment schedules that do not match with their financial situation or cash flows.

Because there are considerable differences in the design of micro-lending, entrepreneurs should understand how to compare microfinance institutions to each other. 

The components that make up the micro-lending processes include eligibility and credit assessment, collateral, repayment schedule, interest rates, fees, and loan default and loan collection.

• Eligibility and credit assessment. Your qualifications and credit history may determine which microlenders you are able to pursue. If you’ve been in business for a few years and have a high credit score you may have many choices. Many entrepreneurs just starting out may have fewer options. Microlenders will want to know how long you’ve been in business and whether your revenue can cover your expenses as well as a new loan payment. Be prepared to provide detailed analysis of the business finances and household cash flow. Don’t overestimate your income and don’t underestimate your expenses. Be honest about your financial situation. Your credit history, either through credit score, or perhaps character reference, will also be evaluated.
• Collateral. Microfinance institutions, similar to traditional banks, typically require some form of collateral to back up the loan. In the event the business were to fail, or the borrower could no longer afford the loan, the microlender would take over the collateral to pay back the loan. Collateral could be business or personal assets. If there is not sufficient collateral in the business, a microlender may consider collateral substitutes such as co-signers or personal collateral. Some microlenders may use compulsory saving as a collateral substitute. This means the borrower would be required to create and contribute to a savings account during the loan, which would take money out of your income that you may need to pay other expenses.
• Repayment. Paying for your loan is called “servicing your loan” and the monthly payments are called the “repayment schedule.” Your ability to keep to your repayment schedule will impact your credit score and credit history. So it’s important to stay on schedule and pay the full amount. You are always building your credit worthiness.
• Principal and interest. All loans are repaid through payments called installments. Each installment includes some money that goes toward the debt, or principal, and some money that goes to the interest. Interest is the extra money added to the loan calculated based on a specified rate. Interest, as well as any fees, are the cost of borrowing the money.
• Repayment schedule. Some microlenders may set a monthly payment schedule for one set amount, or they may set a schedule based upon the business cash flow. While a more flexible payment schedule may sound like a good idea, it might be difficult if there are unexpected changes in the business. Also, some lenders may have fluctuating (or changing) payment schedules. This means you might pay daily during some months and make monthly payments at other times. This practice can hide interest rate changes so you may not realize you are paying more. Some lenders may also offer loans for which you only pay interest initially, and then add principal payments later, or one big payment of the entire principal at the end. This is called a balloon loan. These loans can be very risky. It may seem more affordable to only pay interest in the beginning, but it can be a big shock when the payments increase significantly. 
• Interest rates.
• Annual percentage rates. Traditional banks provide interest rates in terms of annual percentage rates, or APR. 
• Factor rate, daily rate, monthly rate. Other lenders, including microlenders may use different terminology, such as a factor rate, a daily rate, or a monthly rate. These can be difficult to evaluate and compare. For example, a loan with a 10 percent annual interest rate might seem more expensive than a loan with a monthly rate of one percent. However, calculating one percent for 12 months gives an annualized interest rate of 12 percent. This might not sound like a big difference, but some microlenders might advertise monthly rates of 10 percent! Some “low” rates translate to very high annualized rates, topping very high two-digit and even high three-digit percentages! So be sure to understand what is meant by the rate you are quoted and figure out how to compare loans based upon an annualized interest rate.
• Percent of receipts. Some lenders will provide a loan and negotiate a rate that is a certain percentage of your business’s revenues or receipts. This could be as low as 10 percent or much higher.
• Fees. Lenders will often include certain fees in the terms of their loans. The most common are origination fees, late payment fees, prepayment fees/penalties, administrative fees, and risk assessment fees. Your loan may not have all of these but it’s important to know what they are.
• Origination fee. There may be a fee to start the loan, this is called an origination fee. 
• Late payment fee. A late payment may result in a late payment fee or a higher interest rate for a period of time, or going forward indefinitely. 
• Prepayment fee. There may be prepayment fees for paying a loan off early, because the lender gets less of your money overall if you pay it back before they collect all of the interest that would be paid over the term of the loan. For example, if you borrow $5,000 over 5 years for 10% annual interest rate your total amount owed would be $6,374.11, with monthly payments of $106.24 (assuming a simplified loan with no additional fees). If you decided to pay $230.72 a month, you could pay back your loan in two years and save $836.72. However, if there is a $500 prepayment penalty, you would only save $336.72. You can therefore calculate whether the fee is worth paying back the loan early. Some lenders may require payment of the full contract amount regardless of when you pay it off. Be sure to understand both late payment and early payment consequences of your loan.

A simplified example showing prepayment scenarios of a five-year $5000 loan with 10% APR:

• Administrative fee. Some lenders may charge a monthly administrative fee. Be sure to do the math. While $10 a month may not sound like a lot of money, include it when you calculate the total cost of loan.
• Risk assessment fee. A risk assessment fee may be added if the lender determines you present a higher risk due to your credit history, duration of the business, limited collateral, or other reasons.
• UCC fees. Lenders in the US may file a legal notice with the secretary of state, called a UCC filing, when they have a security interest against one of your assets. A UCC filing on your business credit report may signal to other lenders later that your business is not financially stable. Even if you pay off a loan UCCs can stay on your report. Be sure to ask your lender to remove your UCC once the loan is repaid. There could be UCC termination fees as well.
• ACH fees.  Automated Clearing House (ACH) is a network used for electronic payments between banks in the United States. Some banks charge a fee to send money in this network.

• Loan default and loan collection. Entrepreneurs should clearly understand what actions the lender would take in the event he/she could no longer afford the loan, known as “defaulting on the loan.” Some lenders might take the borrower’s business equipment, household appliances, livestock, or any other items that were put up as collateral by all co-applicants. Some lenders might rework a borrower’s repayment schedule to get through the hardship. Be sure to understand the terms of any new loan structure to ensure you can afford it. If your business recovers faster than anticipated, would there be an opportunity to update the terms once again?

Before taking out a loan, make sure to carefully read and fully understand the terms and conditions of the loan. Take all of the factors into consideration and don’t just focus on one aspect of the deal such as interest rate. Don’t assume that the lender will provide adequate information on how microloans work, the expected repayment schedule, and the penalties for not repaying on time. Ask the lender any questions along with clarifying answers as you feel necessary before making the decision.

It’s also important for borrowers to know that as they near the end of their loan, their lender may not want to lose them as a client. So there may be attempts to lure borrowers into another loan by offering attractive terms that help “pay off” the old loan while getting started on a new loan. The new loan could allow the borrower to have extra money on hand just in case. Be careful about pursuing these loan options. It’s a good idea to only borrow what you need at the time to avoid getting into a cycle of debt by taking on new debts at the end of your term to pay down existing debts and gain access to money you don’t need.

There are various free tools available online to help you calculate the full cost of your loan such as this one provided in English and Spanish by Practical Money Skills, a Visa program: https://www.practicalmoneyskills.com/en/resources/financial-calculators/loans/loan-cost.html

MOBI Partner the Community Economic Development Fund (CEDF) in Connecticut provides this helpful list of steps new entrepreneurs can take to prepare for a small business loan. Read the full CEDF guest post on this topic on the MOBI Blog for Entrepreneurs here. 

12 Smart Tips for Getting a Small Business Loan

1. Be ready to show how you can pay it back. This is the most important thing lenders will want to know. Don’t overstate your expectations, be realistic. 
2. Expect to personally guarantee the loan. Entrepreneurs don’t always have enough suitable assets in their businesses to guarantee a loan. So the lenders will require a personal guarantee from the business owner and any co-applicants or additional guarantors. 
3. Realize it’s not just about the business. Lenders will calculate “global debt service” which means your ability to pay all of your personal and business debts. 
4. Be candid and upfront about your financial condition. Not everyone has a perfect credit and financial history. Share details about any current or prior issues that could negatively impact your application. 
5. Be realistic about how much you need to borrow. Be sure you raise enough capital, either debt or equity, to launch your business and meet your early working capital needs, but not so much that you can’t afford the payments.
6. Accept that it’s not the lender’s job to provide you with enough money. Make sure that you have access to additional sources of funding to face unexpected circumstances while continuing to repay your loan.
7. Understand the purpose of a business plan. What’s important is that you show that you understand your own operation and market, you can communicate the essentials of your business, and you have done enough research to provide realistic calculations to predict future financial results. 
8. Realize the lender can’t help you create your business plan. Entrepreneurs can seek assistance with business planning from a variety of sources including SCORE mentors (you can find a free mentor by providing your zip code at SCORE.org), local Small Business Development Centers (SBDCs), certified public accountants (CPAs), and others. It’s also very important to continually update your business plan because circumstances change all the time. 
9. Arm yourself with at least basic financial knowledge. Learn financial fundamentals through a variety of resources such as MOBI’s Accounting and Cash Flows session.
10. Appreciate the differences in sources of business loans. Each source of funding has its own pros and cons. Find the best source of funding for your business and your financial position.
11. Let the borrower beware. Be sure you understand the effective interest rate of your loan. 
12. Community development financial institutions like CEDF are another source of lending for small business. Check with your city’s economic development office, your region’s SBDC, or the commercial lending department of your bank to learn which community development financial institutions are active in small business lending in your area. Many operate as nonprofit organizations and often can be more flexible in their criteria than a bank because they are mission-driven to improve their communities.

Carefully evaluate your needs, expenses, incoming earnings, and predicted future earnings. Don’t take more than you need, because this can lead to excess debt that you will need to pay. At the same time, don’t take less than you need, because you could have a cash shortage when unexpected expenses emerge. Be sure you calculate the cost of the loan in your planning. Considering the monthly payments you’ll need to make for the loan, will you have enough money to pay all of your other bills and expenses for the business?

Traditional banks might be a good source of funding if you are looking to borrow a large amount, assuming that you meet their qualifications.

Plan and detail exactly what you will use the loan money for and how it will impact your revenues. For example, are you borrowing money to buy equipment that will allow you to double your production capabilities?

These are items that should be included in the financial areas of your business plan.

The delivery of the loan product is generally done through group lending or individual lending. Be sure you understand the method your lender will be taking to provide and manage your funds and match your personal and business needs to the delivery method of your lender.

• Group lending. In these scenarios the microlender creates groups of borrowers and provides one loan that gives money to each borrower. You may also be asked to provide names of others who need a loan and can be in your group. The entire group is responsible for the loan, and the individuals are jointly responsible if one of the group’s members defaults on repayments. So the groups or group leaders help enforce the terms and provide peer pressure to ensure payments. 
• Individual lending. These microlenders give money directly to the individual rather than the group. 

Here is a comparison of the two methodologies:

In recent years there has been a lot of growth in internet banking and FinTech (financial technology) organizations that bring new technology to financial services to provide lending options for small businesses. In addition, smartphones have made it possible for people to conduct financial transactions anywhere. Entrepreneurs can use their phones to save, send, and spend money wherever they are. Thus, a microfinance institution that utilizes mobile technology to process microloans may have lower costs that they can transfer to clients, lowering the transaction costs for entrepreneurs. However, these microlenders may also have higher rates because they are assuming greater risk. Borrowers should follow the same guidance in evaluating these lenders as they would for any others. 

The organizational form of the microfinance institution also has an important impact for entrepreneurs. In most countries, microfinance institutions fall between for-profit and nonprofit status. 

• Nonprofit or client-centered microfinance institutions tend to adhere to client protection standards even when regulations are not in place. 
• For-profit or commercialized microfinance institutions tend to expect that potential borrowers should know the implications of obtaining and repaying a loan.

Be sure to evaluate two lenders from each category when investigating loan options. 

If you borrowed money in the past and had trouble keeping up with payments, or had difficulty keeping your personal and business finances separate, learn from those mistakes to do it differently this time. Create a way of organizing your finances that is easy to maintain and that can give you a quick snapshot of your financial situation. This may be creating separate bank accounts, using a spreadsheet to track personal and business income and expenses, or using bookkeeping or accounting software to help you learn about and track finances. You can also hire a certified public accountant or bookkeeper to help you. Many work on a freelance basis so they can be hired for a one-time project or an ongoing basis.

Continuously seek financial and business education and training before, during, and while taking out microloans. This includes finding mentors that could provide encouragement, growth, and improvement in your personal and business endeavors. You may find new opportunities for affordable capital!

THE TOP TEN DO'S

1. When looking for a microfinance loan, know exactly how much you need in terms of loan amount. 
2. Know ahead of time how you will use a new microloan in generating revenue in order to be able to repay back the loan amount plus the interest on the loan. 
3. When choosing a microfinance institution or lender, make sure to evaluate more than two lenders based on the lender’s legal status (nonprofit or for-profit) and consumer protection approach (client-centered or institution-centered).
4. Make sure you match your personal and business needs to the lender’s lending methodology: group lending or individual lending.  
5. Before taking out a loan, make sure to carefully read and fully understand the terminology, terms, fees, and conditions of the loan.       
6. Know the lender’s policy on eligibility and credit assessment, collateral substitutes, and interest rates. 
7. Know precisely the lender’s repayment schedule policy and the penalties for late repayment or prepayment. 
8. Know exactly the lender’s collection policy when there is a loan default, including whether your valuable personal and business assets can be taken away, as well as those of any co-applicants.
9. Learn from your mistakes whether from a previous microloan or from prior bad business habits such as not separating personal spending and business spending.
10. Continuously seek financial and business education and training before, during, and while taking out microloans.  

THE TOP TEN DON'TS

1. In regards to loan amount, don’t take more than you need because you will need to pay interest on the money even if you don’t use it for your business. At the same time, don’t take less than you need, you could have a cash shortage when unexpected expenses emerge.   
2. In applying for a loan, don’t overestimate your income and don’t underestimate your business expenses. Be honest about your personal and business financial positions.
3. In looking for a loan, don’t assume that the lender will provide adequate information on how microloans work, the expected punctual repayment schedule, and the penalties for not repaying on time. Be sure you ask questions and understand all aspects of your loan.
4. Don’t take out more than one loan at a time. Taking on multiple loans can create a cycle of debt and put your personal and business standing at risk.
5. In deciding on a microloan, don’t focus on just one aspect of the deal. Focus on a range of factors such as interest rates, fees, repayment schedule, penalties for late repayment, and loan default. 
6. Don’t assume a financial institution is regulated by the government to adhere to consumer protections.
7. Don’t compare daily or monthly interest rates to annual percentage rates without first annualizing them. A 1% monthly rate is actually higher than a 10% APR.
8. Don’t forget to ask about any and all fees that have been added to your loan or could be added throughout the loan term.
9. Don’t make the same mistakes over again. If you had trouble keeping personal and business income and expenses separate, find a different way to track your finances.
10. Don’t end your business and financial education just because you got the loan. Continue to learn and you may find other opportunities for affordable capital.