Microfinance
What is Microfinance?
Microfinance is the supply of small loans, savings accounts and insurance to low-income borrowers whom commercial banks turn away for lacking collateral.
Traditional lenders want collateral and a credit record, which a street vendor or a smallholder farmer does not have. Microfinance institutions substitute other devices: group lending, where a handful of borrowers guarantee each other and nobody gets a new loan if one defaults, frequent small repayments starting soon after disbursement, and loan sizes that grow only when the last loan was repaid. Grameen Bank in Bangladesh popularized that model, and its founder shared a Nobel Peace Prize for the work. Interest rates are high compared with commercial bank loans, because assessing and collecting a very small loan costs nearly as much as a large one. Careful randomized evaluations find borrowers do invest more in their businesses, but effects on average household income and on escaping poverty are modest.
Microfinance: a worked example
A vendor borrows 10,000 units at a quoted flat rate of 20 percent for one year, repaid in 50 equal weekly installments. Interest is charged on the full 10,000, so she repays 12,000 in total, which is 240 a week. But she does not hold 10,000 for the whole year; she has paid down roughly half of it on average, so the true cost of the credit she actually used is closer to 40 percent. That gap between the quoted flat rate and the effective rate is one reason microfinance interest looks cheaper in the brochure than in the borrower's accounts.
The mistake students make with microfinance
The story students carry is that a small loan reliably lifts a family out of poverty. Randomized studies across several countries find a more limited picture: business investment rises and households gain flexibility, but average income, consumption and school enrollment change little. The second error is thinking microcredit is cheap or charitable. Rates well above commercial bank rates are normal, and they reflect the real cost of administering tiny loans rather than pure profiteering.
Microfinance questions
How does group lending replace collateral?
Group lending replaces collateral by making borrowers jointly responsible, so the group has a reason to screen and monitor each other. Members know who in the village is reliable, information a distant bank cannot get, and nobody in the group receives another loan while one member is in default. Peer pressure and the promise of future credit do the work a house deed would do at a commercial bank.
Why are microfinance interest rates so high?
Microfinance rates are high mostly because the cost of making a loan barely falls as the loan gets smaller. Screening a borrower, handing over cash and collecting weekly payments in person cost roughly the same whether the loan is 100 units or 10,000, so that fixed cost is a much bigger share of a tiny loan. Lenders also carry funding costs and defaults, though repayment rates are usually strong.
Does microfinance actually reduce poverty?
The evidence says microfinance helps some borrowers without producing the large poverty reductions once claimed for it. Randomized evaluations in several countries find more business investment and more control over the timing of spending, but little average change in income or consumption. Access to savings accounts and insurance often shows up as more useful than credit alone.
Formula / Example
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