Microlending Definition

What Is Microlending?

Microlending is the method of issuing small loans called microloans to small business owners. These small business owners—often in developing countries—may not have access to traditional financial products or financial institutions. Instead, these small businesses work through non-traditional loan service channels to secure financing needs.

How Microlending Works

The origins of microlending are often tied back to Grameen Bank. Founded in 1976 by Muhammad Yunus, the bank would make small loans to Bangladeshi women who made baskets. This process required a specialized lending institution to be in the vicinity of the borrower to facilitate and oversee the loan.

Microlending is prevalent through government financing as the United States Small Business Association also runs a microloan program. To apply for a loan, a small business must often meet with a local intermediary. This intermediary review’s the business’s application including evaluating a company’s creditworthiness and compliance with loan requirements. Microloans through the SMA may come with the requirement to fulfill training requirements to secure financing. Though microloans can be issued for up to $50,000, the average SBA microloan is $13,000.

Today, microloans are heavily digitized to introduce new lenders to the space. Private microlending platforms often require a borrower to select a loan purpose and loan amount. Upon receipt of the full application, the lending platform will assess the borrower’s creditworthiness and assign terms to the loan. Some microloan platforms will solicit investments from a variety of private investors before funding the loan.

Similar to other loan products, a borrower often has amortizing payment schedule. This schedule often dictates a fixed payment amount, although the payment usually gradually increases the amount of principal paid each month and gradually decreases the amount of interest paid each month.

Peer-To-Peer Financing

The peer-to-peer economy has revolutionized the way people do business, and the financial sector has seen some impressive advancements leveraging P2P applications. Through peer-to-peer financing, microloans are now small loans that are issued by individuals rather than banks or credit unions. These loans can be issued by a single individual or aggregated across several individuals who each contribute a portion of the total amount.

Through peer-to-peer financing, individual investors can select who to lend money to. Lenders are often required to provide a minimum amount of capital (often as low as $25). Lenders are provided an overview of the borrower’s credit and financial profile. In peer-to-peer financing, the borrower has no say in who the lenders are; the borrower can only select the peer-to-peer lending platform that will facilitate the loan.

How Do Consumers Use Microlending

Microloans may serve one of two main purposes. The first is to help small businesses in Third World countries start their operations. In these situations, there is often no financial institution physically available in the geographical area. The lenders are individuals who pledge a certain amount of money to loan out to a deserving entrepreneur in another country.

Companies like Kiva administer microlending for these humanitarian purposes. Borrowers will describe the type of business they wish to start, how it will operate, and present a business plan outlining day-to-day operations. Borrowers will often also feature a personal story and a short biography.

The second purpose is to lend to individuals who may have bad credit and cannot obtain credit from a bank or who seek to borrow small amounts of money that are below the amounts required by a bank. Lending Club and Prosper are two companies that administer peer-to-peer microlending for these purposes.

A borrower may seek funding for any number of reasons, which are made explicit to potential lenders. If the lender does not trust the borrower they will elect not to fund that particular loan. In some cases, loans may not be fully funded because they cannot attract enough lenders to contribute. These companies typically earn a profit by charging fees to originate and maintain loans that are then added to the borrower’s interest rate.

Microlending Risk and Reward

There are specific reasons a borrower and a lender may be interested in entering into a microloan. Often, an advantage for one party is a disadvantage for the other. Let’s review the pros and cons for both.

Microlending for Borrowers

Microlending has been facilitated by the rise of the internet and the worldwide interconnectivity that it brings. People who wish to put their savings to use by lending and those who seek to borrow can find each other online and transact. For this reason, it is often easier for a borrower to secure credit because there are now more lenders interconnected across the globe than ever before.

The credit rating of borrowers is imputed using data (including whether or not the borrower owns a home), a credit check or background check, and repayment history if the borrower has participated in microloans in the past. Even those with excellent credit scores may expect to pay slightly more than traditional credit.

Because of the short-term nature of microloans, the borrower is often not required to post collateral. However, these loans may have a much shorter payback timeframe compared to other loans. In addition, the borrower may be restricted on how they are allowed to use the funds.

Microlending for Investors

If a borrower defaults, the lender may expect little or nothing to be recovered. On Prosper.com, the best-rated borrower can expect to pay a minimum of 7.99% annually on a loan, and the riskiest borrower will pay an interest rate of up to 35.99%. If an investor thinks that 7.99% (less fees) for a relatively safe loan is worth the risk, the loan may produce outsized returns compared to other forms of lending. 

Because of the inherent risk of any single microloan, lenders often invest only a small amount per loan but may fund a portfolio of many dozens of microloans. Therefore, any individual borrower may find their loan is funded by a large number of lenders, each contributing a small percentage of the total amount. By spreading the risk across a wide array of loans with different credit qualities and other attributes, lenders can ensure that even if one or two loans default, their portfolios will not be completely wiped out.

Although lenders may diversify across an array of loans, all microloans through peer-to-peer lending platforms are subject to the same economic risk. For example, the COVID-19 pandemic was statistically shown to broadly increase the likelihood of a borrower defaulting on a loan. Other widespread macroeconomic impacts like monetary policy or global conflict can often not be diversified away across different microloans.

If investors are comfortable with the risk, it is often very easy to get started with microloan investing. Most lending platforms will require investors to create a profile, validate their identity, and confirm their tax information. These microloan platforms will then communicate investment opportunities, oversee the administration of the loan, and provide tax forms when appropriate.

Microlending Organizations

As technology continues to innovate, more organizations have entered the microlending space. Although the list below does not encompass all microloan options, it should provide both borrowers and lenders a good overview of who the major organizations are in the industry and how they may compare to each other.

• LendingClub: Microloan terms are between one and five years. Investors are assessed a 1% fee on all payments received, and microloans range from $1,000 to $40,000.
• Peerform: Microloans begin with rates as low as 5.99% with a maximum loan value of $25,000. There are no prepayment penalties on the loans with a maximum term length of five years.
• Upstart: Microloan investors must be accredited and requires minimum investments of $100. All payments received are subject to a 0.5% annual fee. Loan terms are often either three years or five years.
• Prosper: Microloan investing starts at $25 with an annual loan servicing fee of 1%. Investors are not permitted to invest more than 10% of their net worth.
• StreetShares: Microloans start at $2,000, although small businesses can not require more than 20% of their company’s annual income. Loan repayments occur every week.
• Funding Circle: Microloans are paid in monthly installments, and the platform specializes in small businesses. Investors must deposit at least $25,000 into an investment account before allocating as little as $500 to individual loans.
• Kiva: Microloans are as small as $400, but investors can finance as little as $25. This international nonprofit lender specializes in global small business lending.

The Bottom Line

Microlending is a financial innovation made possible by technology and the peer-to-peer economy. People looking to lend money to earn potentially high returns may fund borrowers who either have no access to credit due to geography or cannot get credit from traditional sources, such as banks or credit unions.