Microloans are very small loans usually offered to borrowers or small businesses that lack a credit history or proper collateral. They’re intended to encourage entrepreneurship and alleviate poverty.
What Is A Microloan?
As a small business owner, you may need cash quickly, but you might not be comfortable with taking out a large bank loan. Perhaps you just need a bit of extra money to pay workers in your business or to run a marketing campaign that will boost your sales.
Short term loans with a low interest rate may serve your needs in these types of situations. One option for a loan is called a “Microloan.” A microloan is a short-term loan with a relatively low interest rate extended to self-employed individuals or small businesses. The typical amount of these loans ranges between $500 to $50,000.
Banks generally don’t offer low-dollar loans; therefore, you’ll likely access microloans from other financial institutions. Some microloans are accessible to any small business owner or self-employed individual. Other microloans provide financing to specific groups of entrepreneurs (for example, low-income communities or female entrepreneurs).
How Does a Microloan Work?
A microloan can be in the form of a conventional installment loan or a Peer-to-peer loan.
With an installment loan, borrowers receive the full loan amount from one lender and make installment payments of the principal amount plus any interest accrued. With a peer-to-peer loan, multiple individuals or institutional investors fund the loan amount through a lending platform.
The application process for microloans may differ from lender to lender, but some general principles apply.
An important aspect that lenders consider when you apply for microloans is your credit score. Your credit score helps lenders determine how likely you are to default or pay back the loan. Therefore, if you have a good credit score, lenders are more likely to approve your loan application.
You can also increase your chances of loan approval by presenting yourself professionally. That usually means providing a clear plan on how you’ll spend the money.
Some of the documents and details required when applying for the loan might include:
- Identification
- Financial documentation
- Your business plan
- Collateral
If lenders approve your application, they can provide funding by check or through a direct deposit into your bank account.
What are SBA Microloans?
SBA microloans are loans provided under the United States Small Business Administration’s (SBA) microloan program. The SBA is a federal agency founded in 1953 to protect the interests of small business owners within the United States.
The SBA Microloan program provides loan amounts up to $50,000, which help small businesses and various not-for-profit childcare centers to start up and grow. The SBA provides this funding to specially designated intermediary lenders that are nonprofit, community-based organizations that have experience in lending, management, and technical assistance.
These designated intermediary lenders then provide funding under the Microloan program to eligible borrowers.
Businesses can use the SBA microloan program to address various expenses, including:
- Employee salaries
- Supplies
- Furniture
- Machinery
- Equipment
Borrowers are restricted from using SBA microloans for real estate investment or paying off debt. There may be other restrictions and qualifications as well.
How are Microloans Different from Traditional Bank Loans?
Microloans are specifically designed for small businesses that require low amounts of cash compared to traditional bank loans. In that regard, microloans have several features that are different from a traditional bank loan.
Microloans generally provide lower loan amounts compared to bank loans. According to the Congressional Research Service, the average microloan amount is about $14,735. In contrast, the Federal Reserve reveals that the average small business bank loan amount is $633,000.
On the other hand, microloans tend to have higher interest rates compared to bank loans. According to the Congressional Research Service, the average interest rate for microloans is about 7.5%. In comparison, loans from banks or credit unions may have an annual percentage rate (APR – the annual interest rate reflecting loan interest rate and other fees) ranging from 4% to 13%.
Microlenders (lenders offering microloans) tend to be more willing than banks to take on risk and may advance loans to borrowers with less than perfect credit. If you present an impressive business plan, you stand a chance of securing funding even if you don’t have an excellent credit score.
The minimum credit score requirement for SBA microloans ranges from 620 to 640.
Microlenders tend to offer more than just microloans. Some microlenders even offer finance/ business counselors to help you develop business and marketing strategies. This is different from conventional banks that simply offer loan services.
Unlike bank loans that tend to finance large expenses, microloans provide funding to cater for relatively small business expenses, like:
- Marketing expenses
- Buying inventory or supplies
- Working capital
- Buying machinery or equipment
- Buying furniture or fixtures
Since the maximum microloan amount is about $50,000, you may need a bank loan if you want financing for larger amounts of cash.
What is the Difference Between Microloans and Microcredit?
Microloans are mainly targeted at small businesses. It also includes non-credit activities, such as consultation by business professionals to help you develop effective business strategies. Microcredit is different from microloans because it is mainly targeted at low-income earners who may not have enough collateral for other funding options. Microcredit is an extremely small loan intended to help borrowers become self-employed or grow a small business.
Microcredit typically doesn’t require collateral, and it mostly serves borrowers in developing countries. In Latin America, the average microcredit loan amount is $2,000. In comparison, the average microloan amount is about $14,735, according to the Congressional Research Service.
Microloans and microcredit have some similarities, as lenders offer non-credit services in both cases. Microcredit lenders offer non-credit activities like vocational and business training programs and micro savings, as well.
Why Would a Small Business Need Microloans?
A small business owner may be turned down by banks when applying for a loan due to the stringent qualification requirements. Microloans can serve the needs of these small businesses by offering lower qualification requirements.
Small business owners may not have enough collateral required by banks, in the form of property or assets. Collateral serves as security , and is tied to the loan so that the bank may take the collateral as payment if you fail to pay back your loan. Therefore, banks may require larger amounts of collateral compared to microlenders, since they require security for larger loan amounts.
If you don’t have sufficient cash flow in your business, banks may deny your loan application. A healthy cash flow is necessary to reliably make monthly loan payments. That means that if you don’t have sufficient cash flow, you may not be able to keep up with payments on a higher bank loan, but can repay a lower-dollar microloan.
Your personal and business credit history and score play a significant role in qualifying for a loan and determining the interest rate offered by banks. If you’re just starting your business, you may not have a favorable business credit history, which may reduce your chances of qualifying for a bank loan.
Some aspects that can affect your business credit history include cash flow and missed payments to lenders or vendors. Since microloans are specifically designed to help small businesses grow, you may have a better chance qualifying for a microloan if you don’t have an excellent credit history and score.
A small business may only require a small amount of financing, which may not be accessible through a bank loan. Banks typically provide large loan amounts. These are profitable to lend, since the costs of lending smaller amounts are similar to the cost of lending large amounts. Fortunately, microloans are designed to serve small businesses that need small amounts of funding.
Banks are also more risk averse than microlenders. For that reason, banks are less likely to approve loans to small businesses that may not grow or may not make payments on time. This is different from microlenders that also provide non-credit services to help small businesses grow.
How Can You Qualify for Microloans?
Microloans offer easier qualification requirements for small businesses compared to conventional bank loans. The requirements for microloans are flexible, and they may vary from one lender to another.
When you apply for a loan, some of the factors microlenders consider include:
- The duration of operation of your business
- The loan amount requested
- Location of your business
- Your financial track record
- The lender’s estimated likelihood that you’ll repay the loan on time
If your business is just starting, the lender may request you to provide a comprehensive business plan. Your business plan should indicate:
- How you’ll generate revenue
- Strategies that you plan to use to succeed
- How well you understand your target market
Essentially, your loan approval is based on more than your credit history. To determine your reliability, microlenders analyze your business goals before processing your loan application. This plays a role in approval or denial of your loan application.
The process of applying for a microloan usually involves the following basic steps:
- Finding a certified and reputable lender
- Ensuring all your paperwork is complete
- Drawing up a comprehensive business plan
- Showing evidence of your business financial statements and cash flow
- Defining how you plan to use the loan
- Collecting and including sound credit references
- Identifying the assets you’ll use as collateral (if required by the lender)
- Supporting your claim that you can pay the required monthly installments
- Calculating the amount of funding you need
What are the Limitations of Microloans?
Microloans have several disadvantages and limitations.
Microloans tend to have higher interest rates compared to traditional bank loans. In addition, the amount of money you can borrow from microlenders may be limited because these lenders often depend on donations, government guarantees, endowments, and contributions.
You may not easily access microloans if your area doesn’t have a non-profit microfinance institution.