Microfinance Explained: Types, Features & Benefits

Several small businesses and entrepreneurs from the underserved section of society still do not have access to basic banking services to get their businesses started. Here’s where the concept of microfinance comes in.

What is Microfinance?

Microfinance is a financial service that several financial institutions provide to people excluded from traditional banking services. Various microfinance institutions provide small amounts of working capital in the form of credit. These modest amounts are often referred to as microloans or microcredits.

Some microfinance institutions even provide people with different insurances, direct money transfers, and savings accounts. The main focus of these microfinance institutions is to provide banking solutions to the underserved population in India, such as the people and women in rural areas, to grow their businesses. Microfinance supports entrepreneurs, small businesses, and individuals by offering savings accounts with no minimum balance and insurance options at reduced rates and premiums.

Types of Microfinance

There are 4 different types of microfinance provided by microfinance institutions. These include:

1. Microcredit

   Microcredit is a key component of the broader microfinance sector, which aims to offer financial services like credit, savings, and insurance to low-income individuals. The "micro" in microcredit refers to the modest amounts of money borrowers typically access. Unlike traditional lenders, microcredit institutions may charge different interest rates due to the unique costs associated with providing small loans, particularly in rural areas.

   The cost of extending small loans in rural regions often differs significantly from that of offering larger loans in more developed urban centres. People in rural areas, often with limited income, may need only small sums of money to meet their needs.

2. Microloans

   Some small business owners or entrepreneurs may need capital to get their businesses started. They can do so with micro-loans, which are short-term loans provided by microfinance institutions in small amounts. People who can take a microloan can be anyone – trader, self-employed individual, small retailer, manufacturer, individuals with wages, or women entrepreneurs.

   These types of loans can play a vital role in supporting various business activities, such as starting a new small business, covering payroll for newly hired employees, and ensuring steady cash flow. The primary goal of microloan financing is to foster socio-economic development and aid in the growth of new startups.

3. Microsavings

   Microsavings are designed to help individuals and businesses save in small, manageable amounts. For those with limited income, setting aside money can be challenging, but micro savings make it easier by removing many of the barriers to saving. The interest rates on these accounts can vary based on several factors. There are several advantages of micro-savings accounts, including no minimum deposit requirements, no service fees, and the flexibility to withdraw funds whenever needed. Many microfinance institutions now offer this type of microfinance option through mobile apps, making it accessible for anyone looking to build a consistent savings habit.

4. Microinsurance

   Microinsurance is designed for individuals in the informal sector and those with low incomes, offering tailored coverage that meets their specific needs. Sometimes, national programs fit under this category, addressing local demands.

   Essentially, microinsurance breaks down traditional insurance into smaller, more manageable segments. It proves particularly useful for one-off events, like a short trip or an unexpected medical emergency. Those with limited assets, including small businesses, can greatly benefit from this type of coverage. Many microinsurance providers extend protection to cover business risks, such as crop loss in farming operations.

Features of Microfinance

Microfinance is a great financial tool for individuals who are not able to take advantage of normal banking services. This tool comes with several features to help you understand it better:

• Objective: The main purpose of microfinance is to help low-income groups and small businesses with microloans. This means that microfinance institutions focus more on creating income for businesses that are in the underdeveloped areas of the country.
• Loan Amount: Microfinance institutions typically offer small loans and credit lines, with the specific amounts varying based on factors such as the nature of the business and its geographic location.
• Repayment Tenure: Loans provided through microfinance typically have shorter repayment periods, allowing borrowers to repay the amount in manageable instalments. The repayment schedule is determined by the microfinance institutions, and borrowers are expected to settle their loans within this agreed-upon timeframe.
• Borrower’s Financial Condition: People who use microloans are generally individuals running small businesses with low incomes. Hence, serving the purpose of microfinance, which is providing financial assistance to entrepreneurs and small business owners.
• Collateral Requirement: One of the key aspects of microfinance loans and lines of credit is the minimal need for collateral. Most microfinance institutions provide financial services to both businesses and individuals without requiring any collateral.

Advantages and Disadvantages of Microfinance

Microfinance in India comes with various advantages and disadvantages. As we have seen its main features, it’s time to take a look at the advantages and disadvantages of microfinance:

Advantages of Microfinance

Below are the advantages of microfinance:

1. Reduces Poverty

   Microfinance is crucial in alleviating poverty by offering financial services to those who lack access to traditional banking. By enabling individuals to earn a livelihood, it helps them enhance their quality of life and escape the poverty trap.

2. Encourages Entreprenuership

   Microfinance fosters grassroots entrepreneurship by providing small loans, allowing individuals to launch or grow their businesses. This, in turn, generates positive effects throughout the community.

3. Provides More Accessibility

   People with minimal or no assets often struggle to secure loans from large banks. In contrast, microfinance offers accessible loan options for small businesses with lower earnings. Many entrepreneurs face challenges when it comes to providing the necessary identification or documentation required by conventional banks. Microfinance simplifies the process, making it easier for them to obtain the financial support they need.

4. Opens Opportunities for Women

   It is known to empower women by providing them with small loans that enable them to start income-generating ventures. This financial support helps women achieve financial independence and positively impacts the welfare of their families.

5. Offers Sustainable Growth

   Microfinance has far-reaching impacts on sustainable development, and the banking sector is increasingly incorporating AI technologies. When communities achieve economic independence through microfinance, they are more capable of tackling social and environmental issues, thereby fostering broader development.

Disadvantages of Microfinance

While there are different benefits of microfinance, here are some of its disadvantages:

1. Repayment Pressure

   Microfinance provides the feature of microloans to small business owners and entrepreneurs who usually have a low income. These microloans usually create an added stress of repayment on borrowers, negatively affecting their quality of life and mental health.

2. Comes with High Interest Rates

   Microfinance institutions in India frequently charge higher interest rates on loans to cover their operational costs. While this approach helps them manage their expenses, it can place a heavy financial strain on borrowers, especially those struggling with poverty, and may worsen their economic difficulties.

3. Risks Overborrowing

   Sometimes, borrowers can end up trapped in a cycle of debt, taking out new loans just to pay off old ones. This continual borrowing can be incredibly tough to escape and often leads to ongoing financial instability.

4. Lacks effectiveness

   The impact of microfinance on reducing poverty or boosting economic growth can vary. Its success often hinges on factors like local economic conditions and how effectively borrowers can use the loans they receive.

5. Voids Diversification

   Microfinance primarily targets small-scale income-generating activities. However, it often falls short in addressing wider socioeconomic challenges such as healthcare, education, and infrastructure development, leaving these crucial areas neglected.

Traditional Banks vs Microfinance Institutions

More or less, microfinance institutions work like traditional banks along with a unique operation model, catering towards underserved individuals. Here are some points that make both of these bodies different:

1. Checking Eligibility

   Microfinance institutions take a different approach compared to traditional banks when it comes to assessing loan eligibility. Unlike mainstream banks, which typically evaluate borrower’s salaries and assets, microfinance institutions focus less on financial guarantees and more on personal and human factors. When considering a loan, these institutions are more interested in whether the loan will help the borrower start a new venture or generate income. The decision process often involves conversations with the borrower to understand their situation better rather than solely relying on the application form.

2. Group Solidarity as Security

   Traditional banks often use hypothecation, where assets are pledged as collateral, to secure certain loans. In contrast, microfinance institutions use a group solidarity approach instead of traditional collateral. For example, when individuals invest in mutual funds through these institutions, each borrower acts as a guarantor for the others in their group. This approach is also seen in self-help groups, where mutual support and accountability replace conventional guarantees.

3. Training Sessions

   Microfinance institutions differ from conventional banks in their approach by actively fostering relationships with the recipients of microloans. They provide substantial support to their borrowers, prioritising their success. To achieve this, microfinance institutions often conduct training programs designed to educate borrowers on project budgeting and financial management. Their goal is not just to lend money but to ensure borrowers have the knowledge and skills to make their projects successful.

4. Repayment Plans

   Microfinance institutions typically design their repayment plans to align with the financial realities of their target customers. Unlike traditional banks, some microfinance institutions may offer loans with weekly repayment schedules to better accommodate the income patterns and financial situations of their borrowers.

5. Credit Options

   Microlending offers products that are specifically designed to match the repayment abilities of borrowers. This flexibility is a key distinction between traditional lenders and microfinance institutions.

So, are you ready to unlock your financial potential?