Microfinance: How It Works, Plus Benefits & Drawbacks

Microfinance fills a critical funding gap for entrepreneurs who can’t access traditional bank loans. A skilled artisan in Latin America, for example, might not be able to increase output because they lack enough money for bulk materials, while an entrepreneur with a poor credit history may be rejected by mainstream banks.

This guide explains how microfinance services work, who provides them, and how to access them. You’ll learn the real benefits of micro lending and microsavings, plus the significant drawbacks to watch for before you borrow.

What is microfinance?

Microfinance is a category of financial services provided to low-income entrepreneurs who lack access to the traditional banking system. Although it is best-known for micro lending, microfinance has evolved to include a much broader array of products.

These microfinance services can include:

• Microcredit. These loans, typically capped at $50,000, are used to start or expand a business, purchase inventory, or buy equipment. 

• Microsavings. Secure savings accounts that let entrepreneurs build capital and control their cash flow, often with no or very low minimum balance requirements and minimal or no fees.

• Microinsurance. Policies to protect a small business or family from risks, like illness or crop failure, that could potentially derail the business.

• Financial and business education. Some microfinance institutions (MFIs) bundle their loans with mandatory training. Such programs cover basic accounting and business management to increase their clients’ success, helping to ensure that they can repay loans.

These elements sometimes are combined with additional services to organize the borrower’s entire financial life. The goal of microfinance, a mission shared by international entities like the World Bank, is to promote economic development and give entrepreneurs access to the banking tools most people take for granted. Although part of microfinance’s goal is helping low-income entrepreneurs build sustainable businesses, it also aims to create a pathway for entrepreneurs to generate enough income and contribute to the local economy.

Consider these scenarios:

• Example 1: The local artisan. A skilled weaver from an emerging-market country in Latin America needs enough money to buy raw materials in bulk. A local microfinance institution provides a $300 loan. With this capital, they buy the supplies, double output, and begin selling to a regional cooperative. 

• Example 2: The cosmetic brand startup. A makeup artist wants to establish a cosmetics line but has been rejected by banks for small business loans due to a poor credit history. A domestic microfinance institution (often a non-profit) approves a $5,000 loan. This capital, combined with a financial education course, makes it possible to fund the development of a proof of concept.

What is the history of microfinance?

Although lending is as ancient as finance itself, the microfinance model as we know it is a recent innovation, which resulted from economic challenges in emerging-market nations. The microfinance movement is associated with Muhammad Yunus, an economist from Bangladesh. In 1976, Yunus saw that poor people in a local village were trapped in debt to predatory lenders for tiny sums needed to buy raw materials for their crafts. Frustrated by the banking system’s failure to serve this market, Yunus lent $27 of his own money to 42 women after concluding they were reliable borrowers.

This experiment led to the creation of Grameen Bank. The bank pioneered what are known as solidarity groups, where potential borrowers (often women) formed small groups and co-guaranteed each other’s loans. This use of social capital and peer pressure replaced the need for physical collateral and resulted in exceptionally high repayment rates.

For this work, Yunus and the Grameen Bank were jointly awarded the Nobel Peace Prize in 2006. From this project, the microfinance movement exploded. Key microfinance organizations like the Consultative Group to Assist the Poor (CGAP), housed at the World Bank, helped standardize practices. The Grameen Bank model spread across emerging markets in Latin America, Africa, and Asia, and the industry grew to include both non-profit and for-profit microfinance institutions, all dedicated to serving low-income populations and fostering economic growth.

Where can I get microfinance services?

A variety of organizations offer microfinance services. These microfinance institutions include:

• Non-profit organizations. Many early microfinance organizations were non-profits, such as Opportunity International. Their primary mission is poverty alleviation and community development.

• For-profit companies. As the microfinance industry has matured, for-profit institutions have emerged. They treat microfinance as a viable business model, arguing that a market-based approach is the better way to scale microfinance services to meet global demand.

• Credit unions and cooperatives. These are member-owned financial institutions that often serve a specific community, providing savings accounts and small loans to their members.

• Specialized banks. Some banks, like Grameen Bank, are chartered specifically to serve this market. A growing number of mainstream banks also have dedicated departments for microfinance.

How do I apply for a microfinance loan?

For a small business owner, the microfinance application process is generally more personal and less data-driven than at a traditional bank. This process usually involves the following steps: 

1. Assessment. Instead of relying heavily on a formal credit history or collateral, a microfinance loan officer assesses the applicant’s financial situation and specific financial needs based on other factors. The loan officer’s assessment includes analyzing the business’s current cash flow (even if informal), understanding the entrepreneur’s character (their social capital), and validating the business plan’s viability.

2. Lending model. The microfinance institution will offer either a direct individual loan or group lending. Individual lending is a one-on-one loan and is common in urban areas or those with a more established business. With group borrowing, the institution issues individual microloans to members of a small solidarity group. These borrowers then agree to cross-guarantee each other’s payments, making the group responsible to the microfinance institution if one member defaults.

3. Disbursement and education. Once approved, the loan is disbursed. This is often paired with mandatory financial and business education sessions, covering topics from basic small business bookkeeping to marketing.

What are average microfinance loan terms?

Loan terms are structured to match the realities of small business cash flow. They are, by definition, small loans. A first loan might be as little as $50 to $200 in emerging markets or a few thousand dollars in a developed one. Successful repayment often unlocks access to larger loans.

Unlike monthly bank payments, microfinance loan repayments are often scheduled weekly or bi-weekly. This aligns with the borrower’s daily or weekly sales cycle.

Interest rates are among the most controversial aspects of microfinance. They are almost always higher than those at traditional banking institutions. Microfinance practitioners argue these high interest rates are necessary for several reasons, which include high transaction costs. It takes as much administrative work to service a $100 loan as it does a $10,000 loan, and the microfinance lender earns much less in interest income from these small loans. There’s also risk, because these loans often are not secured by collateral. The interest rates must also cover the cost of the business education programs.

Increasingly, lenders use mobile money platforms for both disbursing loans and collecting repayments. This helps reduce transaction costs and makes the process more convenient for loan recipients.

Benefits of microfinance

Microfinance creates opportunities that traditional banking can’t match:

• Access to capital. Microfinance provides business capital to entrepreneurs without access to the formal banking system, allowing them to buy inventory, invest in equipment, or expand.

• Financial inclusion. Microfinance offers a bridge to the formal financial world. By repaying a microfinance small business loan, an entrepreneur builds a credit history, which can eventually give them entry to traditional financial services. It also opens the way to other crucial financial products like savings accounts.

• Business education. The financial education provided is a critical and often overlooked advantage. Such programs equip entrepreneurs with the skills to manage their money effectively, understand profits, and make strategic decisions. 

• Building social capital. Group borrowing models can strengthen community bonds. This social capital can lead to new business opportunities, shared knowledge, and a strong support network.

• Proven repayment methods. The combination of peer pressure and small, manageable payments results in high repayment rates—often above 95%—making microfinance a stable and reliable model.

• Empowerment and economic growth. Microfinance empowers entrepreneurs to earn a livelihood, create jobs, and contribute to economic growth. This is economic development from the ground up.

Drawbacks of microfinance

Despite its successes, the microfinance model is not without significant risks:

• High interest rates. The most persistent criticism of microfinance is high interest rates. In some markets, for-profit microfinance organizations have been accused of imposing interest rates that trap people in a cycle of debt and borrowing, prioritizing profit over the well-being of borrowers.

• Taking on too much debt. In areas with many competing microfinance institutions, it’s possible for loan recipients to take small loans from multiple institutions to repay loans from others. This practice, often called loan stacking, is typically prohibited by lenders but can be difficult to enforce in markets without an established credit-reporting bureau. This creates a dangerous debt spiral that can ruin a small business.

• Burdensome peer pressure. Although the group borrowing model can be a benefit, it can also be a drawback. The intense peer pressure can lead to social shaming and fractured community relationships if an individual falls behind for legitimate economic reasons—something that doesn’t occur in individual borrowing.

• Doesn’t reach those who need it most. Some critics argue that microfinance doesn’t actually reach those who need it most. Lenders seek out potential borrowers who already have some basic business skills and enough income to show promise, meaning the neediest individuals may still be excluded.

• Limited impact on growth. A microfinance loan can help a weaver buy a new loom, but it’s not the same as the investment capital used to build a factory. Critics point out that although microfinance is good at supporting self-employment, it may not be as effective at fostering the medium-sized businesses that create jobs.

*Shopify Capital loans must be paid in full within a maximum of 18 months, and two minimum payments apply within the first two six-month periods. The actual duration may be less than 18 months, based on sales.