What is microfinancing? (Benefits and why it's important)

By Indeed Editorial Team

Published 29 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Microfinancing is a method of financing for small businesses and new entrepreneurs who might not have access to capital. Microfinancers provide bank loans, credit and savings accounts to low-income or unemployed individuals who want to start or grow their own businesses. Whether you work in finance or you're an entrepreneur, it's important that you understand how microfinancing works and who it benefits. In this article, we answer the question 'What is microfinancing?', discuss how it works and list the benefits and potential drawbacks of microfinancing.

What is microfinancing?

If you're interested in learning more about different financing methods, you may have asked the question 'What is microfinancing?'. Microfinancing is a type of financial service that provides capital to those with low income or unemployed individuals who have no other access to finances. Because these individuals don't have access to other methods of achieving startup capital, including resources from larger financial institutions, they often struggle to grow or start their own businesses.

Microfinance provides small companies with loans that they can use to start or grow their business. These loans typically range between £100 and £25,000. Banks may also offer different types of microfinancing services, such as savings accounts and purpose-built insurance. The goal of microfinancing is to give poor or struggling individuals the opportunity to make money and become financially stable, especially if they can't access more typical methods of financing.

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Understanding how microfinancing works

Microfinancing loans are unique in that they're often given to borrowers even if they have no collateral to pay off the debt if their business fails, such as property or personal items. As a result, interest rates on these loans are usually much higher than typical loans. Although not limited to the developing world, many microfinancing operations are typically available for individuals who may struggle to access financial services and capital.

Sometimes, the individuals who receive a loan may take a money management course or another type of financial education programme before they can access the loan to understand how to manage their finances more successfully. Once they complete their education, they can then apply for a loan. Although these loans might sound small, they can be a lot of money for people in the developing world, and many use them to create successful businesses.

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What are the benefits of microfinancing?

There are many different reasons why microfinancing can be so beneficial, especially for those struggling financially and looking for ways to start or develop their own businesses. Here are some of the main benefits of microfinancing:

It can help break the cycle of poverty

The cycle of poverty is an economic theory that suggests poor individuals or families can stay trapped in poverty for many generations or until there's some form of outside intervention. For example, a family with a low income may struggle with housing and food, which may lead to poor sanitation and health.

If individuals have poor health, they cannot be productive, which may then mean they can't work or receive a regular income. Without this, families cannot break this cycle. Because microfinancing offers some of the poorest individuals in the world the opportunity to gain capital and begin their own businesses, it can help them break the cycle of poverty for generations to come.

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It can improve quality of life

Because microfinancing can help individuals break out of the poverty cycle, it can also improve their quality of life. With the loans, people can set up their own businesses and start making money. They can then use this money to invest in better housing, sanitation and food. Over time, greater access to these necessities can improve the quality of life for all family members.

Once the quality of life improves, more family members then have the energy to work. The more people in the family that can work, the more income they can generate, further increasing their quality of life over time.

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It can empower women

Women, in particular, can benefit from microfinance. Around the world, women make up the majority of those in extreme poverty, and in many countries, they can't access vital financial resources and credit. Many banks and lending institutions in the developing world still tend to focus on offering loans to men, making it even more difficult for women to access the finance required to break the poverty cycle.

By offering poorer women the ability to start their own business, they can start earning money which they can use to feed their families and provide sanitation. These loans can also provide them with access to education, as they're more likely to afford education classes. This can empower them to make better decisions regarding their business and personal life.

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It improves levels of education

Those who live in poverty are much less likely to access education. One reason for this is that the poorest families in the world may make their children work to generate more income for the family. With the help of microfinance, the family may have access to more income, which means that they don't rely on their children's additional earnings.

If children spend less time working, they then have the time to access education, which can improve their skills and, over time, can help to break the cycle of poverty. This education is especially important for young girls because they're less likely to be able to access a comprehensive education.

It's sustainable

Microfinancing is a sustainable investment method because the loans offered are generally quite small. Nonetheless, it can still have a big impact. While impoverished people can use this money to get out of poverty, investors aren't risking much of their own money with these loans. To make these microloans more sustainable, many lenders have high-interest rates on their loans. Although this may make them more difficult to repay, this interest can act as another microloan that lenders can provide to another struggling individual or family.

What are the downsides of microfinancing?

Although microfinancing has many benefits, it's important to note that there's some debate about just how useful microfinancing can be. If you're thinking about a career in finance or looking into microfinancing for your small business, it's important to understand the debates surrounding this method of lending. Here are some of the potential downsides of microfinance:

Interest rates can be a burden

Although microloans can be hugely beneficial for borrowers, the high-interest rates that come with this type of lending can put a huge burden on the borrowers. Although borrowers can use their money to set up their own business, there's no guarantee that their business may succeed. If it doesn't succeed, the borrower may have no way of paying back the loan. As the loan's interest increases over time, the borrower may be in a worse position if they haven't been successful in their business, which can cause stress and further increase poverty levels.

Recipients can use loans for the wrong reasons

Another reason why microloans may not work is that many individuals may choose to spend their investment on necessities such as food and clothing. Although borrowers can spend their loans as they wish, spending them on necessities instead of new methods of generating more income may only push these individuals into further debt.

For example, if someone takes out a loan and uses the money to buy clothes instead of using it to create their own business, they have no means of generating income, meaning that they may require another loan. If this cycle continues, it can result in more debt, higher interest rates and increased poverty.

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There may be a lack of financial understanding

Although some loans require borrowers to take a financial course, many people who use microloans don't have access to education. Because many individuals don't understand how to manage their finances, they may unknowingly spend their microloan unwisely and lose the chance to create a successful business, which may result in further debt. Additionally, because many of these individuals don't have access to a full education, it can make it even harder for them to access loans of any kind.

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