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Finance & Accounting, Small Business Loans

Micro Loans and How They Work

What are Micro Loans?

Updated on August 25th, 2017

While there are certainly different interpretations of what micro loans are, in the most basic terms, they are loans of smaller dollar amounts typically used to help small businesses grow. But, the lenders who are offering these loans and how they are helping aspiring entrepreneurs make them an incredibly fascinating aspect of today’s global and increasingly digital economy. Micro loans are increasing the number of entrepreneurs worldwide and are changing how many small businesses are funding their growth and continued success.

What are Small Business Micro Loans?

Micro loans help enterprising individuals launch and grow small businesses. They promote stronger communities and local economies by supporting families and creating jobs.

In banking terms, a micro loan is a very small loan ranging from $500 to $100,000. Historically, banks in the United States haven’t particularly liked dealing with micro loans because they have not been profitable financial products for them to market. However, alternative lenders are finding innovative ways to help small business owners while also making a profit by offering these smaller amount loans.

Micro loans are one component of a larger micro financing trend that was first developed by a banker in Bangladesh named Mohammad Yunus. As the founder of the Grameen Bank, he won the 2006 Nobel Peace Prize for his efforts in supporting fledgling business owners who were too poor to qualify for traditional bank loans. By developing the concept of offering “microcredit” to these individuals, his goal was to help lift millions out of the grips of poverty through entrepreneurship. His concept has led to the development of thousands of micro lending organizations worldwide.

In 1974, Yunus’ bank was the first lender to develop a microcredit program with fair interest rates and no collateral required. Since then, similar programs have sprouted throughout the developing world, and many economists believe that micro credit schemes have been a big factor in helping improve the lives of countless numbers of people in many impoverished areas around the world. Currently, it is estimated that there are more than 200 million recipients of micro loans worldwide with nearly $75 billion in outstanding debt.

Micro Loans in the United States

Of the 200 million recipients of micro loans, only a small fraction is in the United States. Nationwide, only 400 financial institutions offer micro loans with the average micro loan amount in the United States being approximately $13,000.

However, micro loan popularity has increased dramatically in the last five years due to the financial crisis of 2008 and the extended recession that is still being felt in many areas of the country. There is still low availability of small business loans through traditional banks, and the drop in real estate prices has prevented many from obtaining home equity loans to finance businesses. This has been compounded by foreclosures, layoffs, and other significant financial issues that have impacted the credit reports of millions of Americans. This perfect storm of challenging financial times and a very tight credit market has led to the increased demand for micro loans.

The growth of the Internet must also be noted when looking at the micro financing trend. Online platforms are enabling large numbers of lenders to invest money in small businesses that they can learn about while having tools to give them confidence that those they lend to will pay them back. This real-time check and balance system has made it both desirable for lenders and borrowers in a way that is very different from traditional bank financing for small businesses.

The SBA Microloan Program

In response to the credit crisis affecting small businesses, the Obama Administration granted $54 million to the Small Business Administration (SBA) in 2009 to enable micro lenders to help entrepreneurs gain access to the funds they need to start and grow businesses. This investment has expanded the reach of the SBA Microloan Program which guarantees loans up to $100,000 to help small businesses and some not-for-profit childcare centers.

Through this program, the SBA works with designated lenders (typically national and community banks) to provide micro loans that can be used for working capital, inventory, supplies, furniture, fixtures, machinery, or equipment. The SBA puts few limitations on recipients of these loans except that they can’t pay off existing debt or purchase real estate with the funds. Borrowers are also required to receive business training to help them utilize their loans wisely and achieve their business goals. These loans typically need to be paid back within six years.

Other Providers of Micro Loans

While the SBA does guarantee loans through their micro loan program, borrowers still need to work with banks during the application process, and creditworthiness is evaluated. Thus, those business owners with less than stellar credit are often at a significant disadvantage, and many simply do not qualify for the SBA Microloan Program.

Due to the recession and the effect it had on many individuals’ personal credit, many business owners have been denied loans through the SBA program. This has led to a need for alternative forms of micro loans. And, there are a variety of financial companies and non-profit organizations that are now trying to satisfy this need in the financial marketplace. Many of these have been launched as online micro lending platforms that directly connect individual lenders with borrowers.

With more options for loans than ever before, small business owners are wise to consider their options before deciding on any one lender – particularly if they are considering a loan with a high interest rate. With increasing competition between the growing numbers of micro loan providers, interest rates have dropped.

  • Accion USA is one provider of micro loans that caters to very small businesses and even home-based businesses. These include street vendors, caterers and small restaurants which often have difficulty in accessing credit. The financial company works with business owners with poor credit and has poured more than $30 million into the hands of borrowers.
  • Silicon Valley has also proven to be a hot spot for micro loan activity due in large part to the increase in technology startups that dot the area from San Francisco to San Jose. The Opportunity Fund is a Bay Area-based micro loan provider that has lent more than $18 million directly to small businesses along with providing micro savings accounts. The organization also offers management training and grant money as a way to further jumpstart the success of small businesses.
  • The Women’s Initiative for Self Employment (WISE), headquartered in San Francisco, is another notable organization dispersing micro loans. Since 1998, the nonprofit has helped more than 3,000 female business owners. WISE makes borrowers complete a mandatory 11 week training course before disbursing funds. This training has led to many WISE graduates success. Businesses that they’ve helped have included cleaning services, daycares, restaurants, and catering providers.

Should You Consider Micro Loans for Your Small Business?

Before you begin the process of applying for any type of business financing, it’s always a good idea to first clearly evaluate where your business is at now and where you want it to go. If money is required to get it from point A to point B, the next step is to consider how much you need and your options for getting these funds.

Many business owners start with their own bank. In some cases, this is the best option. Lines of credit and home equity loans may be the best choice. However, if you have weak credit or a lack of credit, you will most likely need to look elsewhere. This is when a micro loan might be worth taking into consideration.

While micro lenders do review credit, they tend to be more likely to look at the “big picture” when it comes to your business as opposed to just basing their decision on your credit score. This is when a well-fleshed out business plan can come in very handy. Most micro lenders want to talk to you and understand your plans. Having your marketing efforts mapped out, as well as details on your monthly expenditures will help them get a better idea for what you’ve been able to accomplish so far and what you need in terms of financing to grow.

For many small business owners, a small micro loan can make a huge difference in their future success when the funds are invested wisely. And, because the loans are typically very small amounts, there isn’t usually the worry of being burdened by a large loan that potentially will never be able to be paid back. Often, these loans are paid back in a matter of months or less than a year, and installment micro loans can be divided into affordable monthly payments. This can even prepare you for borrowing larger amounts at a later date when you want to take your expansion plans to the next level. Paying back a micro loan can also help your business develop a strong credit rating.

One of the other key benefits of working with a micro lender is the availability to business resources and counselors to help your success. Unlike a traditional bank that simply is in the business of loaning money, a micro lender is often there to help with business plans, develop marketing strategies, and even offer guidance when it comes to your accounting and other financial activities. They have a vested interest in your success, and by leveraging these available business-growing resources, you can actually get a competitive edge over businesses that are only working with banks.

Cons of Micro Loans

Like with any type of loan, there are some negatives to micro loans that should be considered, too. The annual interest rate is typically higher than those offered by banks. On average, the rates range from 12 to 18 percent. Also, if you are requiring a loan in excess of $100,000, a micro loan by definition will not be the right option for your business. Although, a growing number of micro lenders are getting into the business of offering larger loans for some promising startups. If you need a larger amount, it’s worth asking!

If a bank loan and micro lenders are both not the right choice for your business, there are still other options to consider including angel investors, personal loans through friends or family, personal credit cards, and business loans such as those offered by Kabbage.

When funds need to be acquired quickly, Kabbage is often the best choice because it can quickly provide approval and generate a business loan for your business in less than 10 minutes. And, unlike banks, Kabbage uses data generated through business activity such as sales performance, social media statistics, shipping, and other sources to get a broad view of a business’s performance.

How to Wisely Use a Micro Loan

So, you’ve acquired the cash you need to grow. Now what? How you use it can have a profound effect on your future success. Micro loans can be used for the same things as any type of business loan including payroll, inventory, equipment, furniture, fixtures, and machinery. They can cover expenses during slow months and fund the cost of extra help during busy seasons. They can enable you to take advantage of a promising marketing opportunity or when a supplier offers you a great deal on inventory that you resell.

What a micro loan cannot be used for is paying off personal debt or making personal purchases. Having a clear division between personal and business expenses is a must! It also can’t be used to buy real estate or other types of investments. Hopefully, whatever you do choose to use the money for will help you ultimately generate more profit over the long run for your business.

Micro loans are, without a doubt, helping many businesses grow faster both in the United States and globally. Yes, they are for more than the cash-strapped craftsperson in that far away village. They are truly for any business owner who knows that a small amount of cash can make a huge difference when it is used strategically.

 

If you’ve decided that a revolving line of credit is a better fit for your business, turn to Kabbage. Kabbage lines of credit provide flexible access to funding so your business can run on a day-to-day basis as well as take advantage of the unique opportunities that come your way.

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Kabbage Team

The Kabbage Team is here to not only fund the small business loans you need, but to help you grow your business through free marketing tips, webinars, tools and more. Is there something you'd like us to cover or want to get your small business featured on our blog? Send us a note at content@kabbage.com.

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