Microloans: Bettering the World and Providing Outsized Debt Returns

Why do low-income individuals have trouble increasing their socioeconomic status? This question, of course, incites a plethora of valid responses, but the one I want to talk about today is the lack of access to capital. The poor often have either a low credit score or no credit score, making it difficult to obtain the capital they may need to pursue their innovative entrepreneurial idea, increase savings to the point where frictional unemployment to get a higher-paying job (or longer-term structural unemployment to obtain a higher education) is feasible, or even to provide better opportunities to their children. Microloans (also referred to as “microlending” and “microcredit”) are making debt capital more accessible to low-income individuals, thus making the journey out of poverty that much less difficult - especially for citizens of third-world countries.

Through the Small Business Administration’s microloan intermediaries 5,533 microloans totaling $81.5 million were provided in 2019 alone. These microloans are primarily lent to small businesses and non-profit childcare centers in the US that are unlikely to obtain the financing they need in the private sector. The average microloan made through this program was $14,735 and had a 7.5% interest rate. Despite their altruistic intentions and effects, these loans are by no means charity donations; in fact, microloans can outperform traditional bank loans in returns.

Microloans are making it profitable to finance low-income individuals and thus helping to facilitate the journey from poverty to a higher socioeconomic status. So, what exactly are microloans? How are they different from traditional loans? And how could these key differences facilitate outsized debt returns and benefit low-income individuals at the same time?

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The first microloans were lent by an economics professor named Mohammed Yunus. Yunus had become frustrated by the extent of long-term poverty he saw in his native country of Bangladesh. In 1976, Yunus launched the Grameen Bank Project to study the feasibility of offering loans and other banking services to low-income entrepreneurs. Since 1976, microloans have become fairly common in third world countries and have expanded to developed countries like the United States as a way of providing financing to high-risk borrowers (whether due to having a low income or a low credit score).

Microloans are loans, typically made by individuals rather than banks or credit unions, that are below $50,000 in principal value. They are typically targeted at low-income borrowers with low credit scores, but most lenders will happily provide microloans to those with higher credit scores because it reduces their risk significantly. These loan amounts can be provided by a single individual or aggregated across several individuals’ contributions. Microloans are often bundled together to spread out the risk. Microloans also typically have an above-market interest rate, because this form of lending is inherently riskier with a higher chance of default, and because most microloan borrowers do not have significant material assets that could serve as collateral (which is why almost all microloans are not collateralized). Despite the risks of lending microloans, the above-market interest rates can drive outsized returns when compared to more traditional forms of debt.

For the highest-risk borrowers, annual interest rates on microloans can be exponentially higher than the market rates, with rates frequently exceeding 30%. This may lead one to question how these loans could possibly benefit the low-income borrower, given that they must pay a far higher interest rate than they would on a typical loan. However, there are a few reasons why microloans may still be advantageous for borrowers. Firstly, the borrower rarely has to risk any collateral and high default rates are expected with microloans, so borrowers that truly cannot pay their loans are unlikely to lose any of their assets or otherwise be “set back” further than they were before taking out the microloan. Secondly, if the microloan is paid off in the first year, the high interest rate does not affect the cost to the borrower. This can happen, especially in the case of microloans given for entrepreneurial applications and microloans of smaller amounts (less than $5,000). Lastly, the annual interest rate for microloans differs greatly from country to country, with countries like Sri Lanka having 17% annual rates (low for microloans). The United States, as mentioned earlier, has microloans with rates as low as 7.5%, which is not far from traditional rates.

However, rates for some countries are far greater than the 35% global average; Uzbekistan’s average annual microloan rate, for example, is above 80%. So, the applicability of microloans to poverty varies greatly by country. However, the profit potential of microloans is somewhat universal - though microfinance institutions (MFIs - institutional microloan lenders) do incur far more costs related to the administration of loans than do traditional lenders, because MFIs tend to lend smaller amounts to a greater number of borrowers.

The bottom line is that microloans are risky for both the borrowers and the lenders due to high interest rates and high chance of default respectively. However, microloans do offer a higher potential profit than do traditional loans, and the ability to scale down loan offerings to reach a broader market of borrowers that, when properly harnessed, can diversify the higher risk associated with these loans. And while low-income borrowers take on a potentially greater liability than traditional loans would offer, microloans offer them the capital they need and when this capital is used properly, it can pay for itself (such as with an entrepreneurial venture). Microloans also almost entirely eliminate the risk presented to the borrower by collateralization. Finally, depending on the country within which it is provided, microloans may not have a rate far above the market rate.

Prosper and Lending Club are two online platform companies that connect microlenders and borrowers, collecting a fee from each transaction in the process. To date, over $67 billion has been borrowed from these sites combined. In 2006, Mohammed Yunus won the Nobel Peace Prize for his work at the Grameen Bank Project, which by 2008 had amassed a total of 7.5 million borrowers and made loans to people in 82,072 villages (over 97% of Bangladesh villages) with 98% repayment. Today, tens of thousands of MFIs can be found all across the globe, with yet more peer-to-peer (individual lender as opposed to institutional lender) deals taking place every year through websites like Prosper and Lending Club. According to the United Nations, 836 million people (12% of the world population) live in extreme poverty. A study in The B.E. Journal of Macroeconomics found that a 10% increase in the gross microfinance loan portfolio per client could cut the amount of people in the world experiencing extreme poverty by 1.26% (10.5 million people).

Microloans may be the future of financing for low-income individuals and third world countries alike, as they leverage a largely untapped global demographic while providing sweeping economic relief on a macroeconomic scale.