Background
The development of modern communication and transportation technologies has fueled a major shift toward global interconnectedness over the past few decades. The Internet has enabled unprecedented levels of interaction among not only nations and institutions, but also, more notably, individuals throughout the world. This ongoing decentralization of power indicates a multitude of opportunities for people and organizations to become involved with humanitarian efforts and financial exchanges across borders on a more direct and interpersonal level.
Explanation
Global connections allow for peer-to-peer economic interactions to occur, eliminating the need for the involvement of intermediary third parties like banks. Since the development of modern microfinance in the 1970s, microcredit providers have employed these peer-to-peer networks by surpassing institutions and issuing microloans directly to borrowers.
Microloans
Microloans are small sums of money loaned out by individuals, communities, nonprofit organizations, or government agencies to be used by borrowers for start-up costs or further business development. These short-term loans, ranging from $10 to $50,000, are offered to individuals who are unable to utilize traditional forms of lending through banks and similar institutions. This may be the result of a lack of access due to the structure and function of local monetary or banking systems, particularly in countries in the Global South. In the United States, microloans are primarily issued to business owners who lack the credit to be considered eligible for a bank loan, or those who request a smaller amount than banks are willing to offer.
How It Works
Microloans are typically not backed by collateral, or property that the borrower agrees to give up if they are unable to repay their loans. This increases the risk of losses for lenders compared to other loans. For this reason, the interest rates on microloans tend to be significantly higher than other loans. Lenders also mitigate risk by collecting payments in frequent intervals, often monthly, and many invest in a group of borrowers in the form of an investment portfolio to spread out the risk of losses due to default. Unlike banks, microloan lenders typically offer guidance and mentorship for new business owners, often advising entrepreneurs working to build up credit and ultimately qualify for traditional bank loans, if accessible.
The modern model of microfinance was developed by Bangladeshi economist Muhammad Yunus in the 1970s. Yunus established the Grameen Bank model, in which he distributed loans starting at $27 to groups of female entrepreneurs with no collateral based on his belief that credit is a human right. Since the establishment of the Grameen Bank, billions of dollars have been loaned out to business owners, the vast majority of which are female, with a near-perfect repayment rate. Thousands of organizations have emulated this model, reaching millions of entrepreneurs throughout the world and increasing competition among microloan providers. In the United States, microloans tend to be a bit larger, averaging between $10,000 and $13,000. These loans are typically used to cover short-term capital and inventory costs. Most prominently, the Small Business Administration partners with lenders to issue loans of up to $50,000 to business owners.
Applying It
Following the rise of the model popularized by Yunus in the 1970s, microcredit was held in high regard by the global community as a novel method for poverty reduction and female and community empowerment. Yunus even received the Nobel Peace Prize for his contributions in 2006. Despite the global praise, scholars have raised a few important criticisms against the model. Because microloans are typically issued on a short-term basis, borrowers are typically required to make initial payments soon after loans are issued. In some cases, microloan recipients must sacrifice income they typically earn through an hourly job in order to attempt to make their business profitable enough to meet payback deadlines. If deadlines still cannot be met, borrowers may be forced to forfeit their own property or savings to stay afloat. That being said, the repayment rates for microloans are still consistently higher than traditional forms of loans issued by formal institutions. In addition, microloans rely on regular interpersonal communication, particularly in the form of oversight and guidance from loan providers. This connection becomes increasingly difficult to maintain as the microloan industry expands, especially as for-profit providers enter a market initially driven by humanitarian efforts.
Remember that microloans that seem small can have a big impact on businesses in your community and around the world. Keep an eye out for efforts being taken by aspiring entrepreneurs in your area that you might have the means to support. You could even address an issue in your community on your own terms given a small loan to help you get started.
