Microfinance is the practice of extending a small loan or other form of credit, savings, checking, or insurance products to individuals who do not have access to this type of capital. This allows individuals who are living in poverty to work on becoming financially independent so they can work their way into better living conditions.

Since a majority of the world is forced to survive on the equivalent of just $2 per day, microfinance becomes a solution that can help more people be able to improve their living conditions. These are the benefits of microfinance in developing countries and why everyone should consider getting involved in this form of lending.

Advantages of Microfinance

1. It allows people to better provide for their families.

Microfinance allows for an added level of resiliency in the developing world. Even when households are able to work their way out of poverty, it often takes just one adverse event to send them right back into it. It’s often a health care issue that causes a return to poverty. By allowing entrepreneurs to become more resilient through their own efforts at their own business, it gives them the opportunity to make it through times of economic difficulty.

Most of the households that take advantage of the microfinance offers that are available in developing countries live in what would be considered “abject poverty.” This is defined as living on $1.25 per day or less – though some definitions extend this amount to $2 per day or more. About 80% of that amount goes to the purchase or creation of food resources.

By offering microfinance products that can be repaid with that remaining 20%, more households have the opportunity to expand their current opportunities so that more income accumulation may occur.

2. It gives people access to credit.

Muhammad Yunus, who is often credited as the modern father of microfinance, once gave $27 to women out of his own pocket because he saw how the cycle of debt affected their work crafting bamboo chairs. Most banks will not extend loans to someone without credit or collateral because of the risks involved in doing so, yet those in poverty do not have any credit or collateral.

By extending microfinance opportunities, people have access to small amounts of credit, which can then stop poverty at a rapid pace.

Yunus has always believed that credit is a fundamental human right. There are certainly some financial institutions which may disagree with his assessment. Yet without credit, it can be difficult, if not impossible for someone in poverty, to pursue an idea that could bring about a giant payday one day. Microfinance makes that pursuit possible.

3. It serves those who are often overlooked in society.

In many developing nations, the primary recipient of microloans tends to be women. Up to 95% of some loan products are extended by microfinance institutions are given to women. Those with disabilities, those who are unemployed, and even those who simply beg to meet their basic needs are also recipients of microfinance products that can help them take control of their own lives.

Women are key figures in leadership roles in business, even in the developed world. Catalyst has reported that companies with female board directors are able to obtain returns that are up to 66% better in returns on invested capital and 42% better in terms of sales returns than companies with male board members only.

Women also develop others more frequently when it comes to entrepreneurial roles. This comes from coaching, feedback, or investments. Even in the developed world, women helping women is an economic force that poverty can’t stop.

4. It offers a better overall loan repayment rate than traditional banking products.

When people are empowered, they are more likely to avoid defaulting on a loan. Women are also statistically more likely to repay a loan than men are, which is another reason why women are targeted in the microfinance world. There’s also the fact that for many who receive a microloan, it is their only real chance to get themselves out of poverty, so they’re not going to mess things up.

Zenger Folkman published a survey regarding ratings of high integrity and honesty in leadership roles that was separated by gender. The mean percentile of women displaying these traits was 55%, while for men, it was just 48%. In business, the bottom line is this: integrity matters. Microfinance institutions have recognized this and approached women because of this.

As a side effect of this approach, many developing countries are taking a new look at what role women should play in society. Instead of treating a woman as a second-class citizen, or the “barefoot in the kitchen and pregnant” attitude that has been prevalent in the past, the success of women in bring their households out of poverty is evidence that proves women not only have an initiative to get things done, but they produce consistent results.

For these reasons, microfinance institutions see total repayment rates of higher than 98%, though there can be several accounts that are overdue at any given time.

5. It provides families with an opportunity to provide an education to their children.

Children who are living in poverty are more likely to have missed school days or to not even be enrolled in school at all. This is because the majority of families who live in poverty are working in the agricultural sector. The families need the children to be working and productive so their financial needs can be met. By receiving microfinancing products, there is less of a threat of going without funding, and that means more opportunities for children to stay in school.

This is especially important for families with girls. When girls receive just 8 years of a formal education, they are four times less likely to become married young. They are less likely to have a teen pregnancy. In return, this makes girls more likely to finish schooling and then either obtain a fair-paying job or go onto a further educational opportunity.

6. It creates the possibility of future investments.

The problem with poverty is that it is a cycle that perpetuates itself. When there is a lack of money, there is a lack of food. When there is a lack of clean water, there is a lack of sanitary living conditions. When people are suffering from malnutrition, they are less likely to work. A lack of sanitation creates the potential of illness that prevents working days.

Microfinance changes this by making more money available. When basic needs are met, families can then invest into better wells, better sanitation, and afford the time it may take to access the health care they need.

As these basic needs are met, it also means that there are fewer interruptions to the routine. People can stay more productive. Kids can stay in school more consistently. Better healthcare can be obtained. This creates a lower average family size because there are more guarantees of survival in place.

And when that happens, the possibility of future investments will occur because there is more confidence in being able to meet basic needs.

7. It is a sustainable process.

How much risk is there with a $100 loan? Some investors might pay that for a decent dinner somewhere. Yet $100 could be enough for an entrepreneur in a developing country to pull themselves out of poverty. This small level of working capital is sustainable because it’s essentially a forgettable amount.

If there is a default on that money, the interest and high repayment rates of other microloans will make up for it. Then repayments are reinvested into communities so that the benefits of microfinance can be continually enhanced. Each repayment becomes the foundation of another potential loan.

This is why many microfinance products have relatively high interest rates. Some institutions may charge the equivalent of a 20% APR, but others have interest rates which exceed 800%. Although interest is high, recipients are invested into making these products work because virtually all institutions put repayments back into new loans that target the most vulnerable households in the developing world.

8. It can create real jobs.

Microfinance is also able to let entrepreneurs in developing countries be able to create new employment opportunities for others. With more people able to work and earn an income, the rest of the local economy also benefits because there are more revenues available to move through local businesses and service providers.

It’s not just the entrepreneurial level that benefits from job creation through microfinance. Grameen Bank in Bangladesh employs over 21,000 people and their primary financial products are related to microfinance. That’s tens of thousands of jobs that are created by the industry with the sole purpose of being able to drag people up and out of poverty.

9. It encourages people to save.

Microloans are an important component of microfinance, but so is saving money. When people have their basic needs met, the natural inclination is for them to save the leftover earnings for a future emergency. This creates the potential for more investments and ultimately even more income for those who are in the developing world.

Some microfinance institutions have seen an extraordinary number of savings occur when products are extended. The Unit Desai of Bank Rakyat Indonesia counts 28 million savers to just 3 million microloan borrowers.

Now saving isn’t always seen, especially from borrowers, but this is part of the expected microfinance process. Small loans make small financial improvements for households living in poverty. The difference between making $1.90 per day and $2.30 per day is not much in reality, but by definition, that amount takes someone out of extreme poverty.

Instead of big improvements, microfinance allows for small improvements. When enough of those improvements occur, then there is a safe place for people to store their income thanks to this industry.

10. It reduces stress.

There is a valid argument to be made that some microloans go to cover household expenses instead of business needs. Some are using these loans to pay bills or purchase food. It’s true. Yet without this product available, there wouldn’t be an ability to pay bills or purchase food. So even though it may not always be used for business purposes, it still serves a purpose by reducing stress.

Stress cannot be underestimated when it comes to poverty. Even in the developing world, the stresses of poverty can be overwhelming. It causes people to seek out coping mechanisms that are not always healthy. And, in some cases, it may even cause families to break apart.

Sometimes childbirth is a coping mechanism for poverty simply because an extra set of hands means an extra chance for income. By reducing these stress markers, households can focus on the job at hand to provide for themselves, even if that means net income levels for that family may not rise in the near future.

11. It allows people to feel like they matter.

The feeling of receiving a credit product for the first time cannot be ignored. It’s a feeling like you’ve made it. That you really are somebody because you’ve been trusted with credit. This feeling applies to everyone, even in the developed world. When a person feels like they matter, it changes who they are at a core level. Instead of focusing on how they can just survive, then begin to look for ways to thrive.

This brings us back to the stress that poverty creates on people. People, when they are approved for a microloan for the first time, will often have a reaction that is similar to Steve Martin’s reaction in The Jerk when he discovered his name in the phone book.

And this is why Yunus feels that credit is a fundamental right. Without credit, survival is often the best possible outcome. With credit, there is hope that anything can be possible.

12. It offers significant economic gains even if income levels remain the same.

The gains from participation in a microfinance program including access to better nutrition, higher levels of consumption, and consumption smoothing. There is also an unmeasurable effect which occurs when women are empowered to do something in their society when they might not normally be allowed to do so. As spending occurs, these benefits also extend outward to those who may not be participating in the program so that the entire community benefits.

The most important weakness of microfinance is that the effects of raising income levels for the poor can often be questionable. Although it raises the possibility of income accumulation and savings, microfinance products also raise the possibility of creating a further indebtedness that may potentially extend the cycles of poverty for an infinite period of time.

Although some may look at consumption in a negative view, those who have gone without for so long will see improved consumption as a sign that things are getting better. Consumption smoothing allows an entire community to realize the benefits that microfinance can provide.

Disadvantages of Microfinance

1. Harsh repayment criteria

In the absence of the legit working protocol and compliances, Microfinance Companies could adopt a harsh repayment approach that someone would not prefer in the state of the financial crisis. Easy debt never comes with relaxed conditions, and that is something true with microfinance companies as well. Since these companies work under strict compliances, they could manipulate their customer for repayment unethically.

2. Small Loan amount

Unlike mainstream financial banks, Microfinance Companies offers a smaller loan amount. Since these banks don’t ask for collateral against the credit, the disbursement of the large loan amount is practically impossible in their case.

3. High-interest rate

Another problem with Microfinance Companies is that they were unable to render low-interest based loans. This is because they don’t follow traditional banks’ footprint, where the accumulation of funds is easy. Plus, they have to borrow money from these banks to execute appropriately and allocate some part of it for risk management. Hence operating cost per transaction is quite high for them despite the high volume of transactions per day.