How Microlending Works

The word microlending makes the concept sound like it's concerned with very small loans. Indeed, this is usually the case in the developing nations where the bulk of microlending takes place. It's not the dollar amount that necessarily makes a loan a microloan; it's the criteria that borrowers must meet.

Microloans traditionally go to those who are overlooked by large, traditional lenders: the poor, women, those without collateral, entrepreneurs who are stepping into a new field. Microlending pioneer Muhammad Yunus, a Bangladeshi economist and founder of microlender Grameen Bank, described the practice, "If banks lent to the rich, I lent to the poor. If banks lent to men, I lent to women. If banks required collateral, my loans were collateral free" [source: Lovgren]. Grameen Bank's loans also went to the illiterate and those in remote and poverty-stricken rural areas where no banks existed. In 2006, he won the Nobel Peace Prize for his work.

Yunus wasn't the first person to come up with the idea of lending money to people traditional banks reject. Microlending bears a striking similarity to borrowing from loan sharks; it serves borrowers who are viewed as unsuitable for loans from more traditional channels. In fact, microlenders are usurping business from loan sharks in some countries, mainly because there's no threat of violence associated with microlending and interest rates are much lower. The average interest rate on microloans made worldwide is 31 percent [source: Epstein and Smith].

Rather than threatening to break the legs of errant borrowers, microlenders like Grameen Bank and others rely on social pressure to ensure loan repayment. Many traditional societies maintain strict social codes pertaining to repaying what is borrowed. In other words, failure to repay on time places the good name of a borrower's family on the line. Grameen Bank also lumps disparate borrowers into groups. Further lines of credit are opened only when all of the borrowers in a certain group are making payments on their loans.

Microlenders also employ what they call "bankers on bicycles." These are collection agents that make weekly visits to borrowers to collect payments. This method of collection helps ensure repayment of the loans made to entrepreneurs in developing nations because it's convenient for the borrower. The social pressure of a personal visit from a neighbor who works for the lender also increases the likelihood for repayment.

We've seen what microlending looks like on the ground; an entrepreneur makes an application for a small loan -- typically $100 to $1,500 -- makes repayment on a weekly basis with around 31 percent interest included on the principal. It generally follows the structure of a typical loan.

What happens on the other side of the loan transaction (often on the other side of the world) is slightly different than the traditional model. In the first place, the loan is often made by an individual rather than by a lending institution.

Two models for issuing microloans have emerged in the 21st century: for-profit and non-profit. While some large investment firms have created mutual funds devoted to investment in microlending, microlending is increasingly carried out online through individual lenders. Microlending Web sites serve as aggregators where potential lenders can evaluate the needs and validity of the business plans of potential microloan recipients.

We'll look at Kiva.com as a model for the non-profit microlending Web site. Kiva allows loan applicants from countries like Nicaragua, Lebanon, Tajikistan and Mali to submit profiles of themselves and their businesses. Applicants post the amount needed for their loans in U.S. dollars and include what the money will be spent on -- things like agricultural supplies or purchasing wholesale items for resale. Users on Kiva may contribute as little as $25 to an applicant's requested loan amount. Users contribute until the loan is 100 percent funded.

At this point, the loan will either be issued to the loan applicant or a lending group associated with the site will be reimbursed for the loan it's already issued to the applicant. Microlending Web sites typically use third-party lenders (often local community banks) to actually issue the money to the recipient.

The reasons why a person wants to contribute to a loan will lead him or her to either a for-profit or a nonprofit site. Nonprofit sites like Kiva are populated by people who see microlending as a socially responsible cause; their loans will be repaid, but without interest. Other, for-profit sites have become popular as a way to actually make money; in other words, these companies see microlending as an investment.

Microplace.com is emblematic of for-profit microlending Web sites. It follows virtually the same model as Kiva, but it offers individual lenders a bonus for their good deeds: a return on their investment. As one investment writer put it, Microplace offers a fairly high rate of return compared to certificates of deposit (CD) -- as high as 5 percent in some cases. What's more, a 97 percent repayment rate shows that microlending can be a fairly safe investment as well.

The concept behind microlending is a simple one: A $25 dollar loan in the U.S. translates into much more when exchanged for the local currency of a developing nation. On August 10, 2009, 25 U.S. dollars could be exchanged for 73.4 Peruvian soles [source: XE]. You can see how a loan of 1,000 U.S. dollars -- aggregated from a number of individual investors on a microlending Web site -- can really help an entrepreneur start or nurture a small business.

The spirit of capitalism pervades the concept of microlending. With their loans, entrepreneurs can purchase the items they need to support their businesses until they're self-sufficient. Since microlending has taken off around the globe, it's helped make capitalism the standard economic system of an increasingly globalized world.

Some democratic theorists believe that free market capitalism in a globalized world economy reduces the chance that international conflicts will become wars. Once countries become interdependent, trade between nations becomes too valuable to risk by going to war [source: Bandow]. Under this theory, microlending helps prevent conflict by funding budding capitalist enterprises. Microlending contributes from the ground up; it's the opposite of trickle-down economic theory. This is one reason the Nobel Committee awarded Muhammad Yunus the Peace Prize in 2006. "Lasting peace cannot be achieved unless large population groups find ways in which to break out of poverty," the Committee stated of its decision [source: Lovgren].

Microlending has also proven its worth in developed nations. In the U.S., the microloan became a vital tool during the economic crisis that began in 2008. Under the banner of the Small Business Administration (SBA), the U.S. government stepped up funding of its microloan program to $50 million in 2009, an increase of $30 million over 2008 [source: Olson]. These loans proved crucial aids for American small business owners in keeping their enterprises running during the recession -- a time when traditional banks decreased lending and increased criteria for applicants.

While it's truly a noble cause and has helped a great many people climb out of poverty, microlending does have its critics -- and corruptors.

A plethora of studies have emerged since the late 1990s that reject the notion that microlending can work to help end poverty in the developing world. For some, the jury is still out on the veracity of microlending: "We're strikingly devoid of evidence," says one Yale economist [source: Epstein and Smith].

Whether it works or not, microlending has inadvertently cast the very poverty-stricken people it was established to help even further in debt. The success of Grameen Bank and other microlending institutions founded to combat poverty shed a light on what has generally been a vastly overlooked segment of the population: the poor. Microlenders served as a sort of litmus test for traditional lenders, proving -- with a 97 percent repayment average -- that the poor can be trusted to repay loans. In some cases, repayment is made no matter the terms, and some banks have begun to exploit poor borrowers.

A pair of BusinessWeek articles published in 2007 exposed two Mexican banks -- Banco Compartamos and Banco Azteca -- that have emerged specifically to lend to the poor. Using the same model that microlending institutions pioneered, like "bankers on bicycles" for collection and social pressure as a technique to encourage repayment, these banks have been making money by lending small amounts to the poverty-stricken. Unlike microlenders, however, these banks often drive the poor further into debt.

This is due to the high interest rates charged by banks that exploit the poor. Annual percentage rates (APR) often reach more than 100 percent, meaning the borrower must pay twice the original loan amount over the life of the loan [source: Epstein and Smith]. Because these loans are made in traditional societies, repayment rates are as high as microloans made through lenders established to alleviate poverty. Borrowers tend to repay the loans, no matter what the terms -- which in many cases don't have to be disclosed to the borrower.

The corruption of the microlending spirit isn't a specifically Mexican problem. Companies firmly entrenched in the developed world like Citigroup, HSBC Holdings and Zurich Financial Services have purchased stakes in highly lucrative Mexican banks that lend to the poor.

This high rate of return on investment is certainly good for microlenders looking to turn a profit off their loans; those who view microlending as a socially responsible means of investment would be wise to research what these loans would mean for the recipients.