What is microfinance?

Microfinance is a system of financial services provided to the poor designed to help them escape poverty. These services include microcredit (small loans typically between US$50 to $1000) saving and insurance services, and sometimes financial literacy education. The institutions that offer these services are called Microfinance Institutions (MFIs), and are sometimes commercial and sometimes non-profit.

Microfinance and microcredits are grounded in the belief that many poor people remain poor due to a lack of credit and other financial services—and, conversely, that small capital injections can enable significant economic and social improvements for borrowers. Microfinance relies on the thriftiness, reliability, and entrepreneurial vision of poor borrowers. Though the amounts of money are small, microloans can have great impact on people’s lives. A loan of US$100, for example, might allow an unemployed woman to open a roadside food stall, buy raw materials at lower cost, or purchase extra livestock—and those profits, in turn, can be invested to increase the educational opportunities, and improve the health and nutrition of an entire family.

Muhammad Yunus and the Grameen Bank pioneered the microfinance movement in Bangladesh in the 1970s. They were jointly awarded the Nobel Peace Prize in 2006 for the tremendous success of their model in eradicating poverty. Microfinance organizations like Kiva and Microfinance Gateway have also made significant strides in bringing the microfinance process closer to people all over the world, making the question “what is microfinance?” an increasingly common topic of conversation.

How does microfinance work?

MFIs in developing countries often disburse loans to people without any credit history using a strategy called “group lending.” Individual business owners come together with a group of at least five trusted friends to apply for loans.  They act as one another’s collateral, agreeing to cover payments for one another if needed. The group’s loan is the sum of each individual’s loan and needs to be paid back in 16 weekly installments deposited in a bank.  To stay on top of this process, groups typically meet once a week and members alternate the responsibility of making payments at the bank.

Why do our MFIs lend to groups rather than individuals?

Research suggests that groups are safer to invest in than individuals because it creates social pressure that reduces the risk of default. If one person in the group defaults, the entire group will have to start at the base level (i.e. lowest loan amount), or may not be able to participate again. The idea is that if one person is having trouble making payments, the other group members will step in to assist with support and/or payments so that the group can remain involved with Investours.

About microfinance interest rates

High interest rates on microloans are common in the developing world and can reach annual percentage rates of over 100%. Sometimes, these high rates are justified, since recruiting, approving and maintaining rural clients for tiny loans is expensive. Other times, and particularly so in Mexico, the microfinance institution’s profit margin significantly increases the interest rate of the microloans they disburse. In other words, microfinance is powerful and effective, but must be administered responsibly to generate a positive social impact. For more information about the microfinance definition, about microfinance interest rates and policies for specific MFIs, check out http://www.mixmarket.org.

More About Microfinance:

Learn more about our partner MFI in Mexico, Sé Más Microfinanzas, and in Tanzania, Maisha Finance [Internal Link to TZ Partners page].

Want more references to define microfinance? The following pages are great sources to help you comprehensively answer the important question, “what is microfinance?