top of page
Anchor 1

Understanding Micro-Financing

November 2017

Jeff Paddock

To understand the microfinance industry today, it might be best not to define what it is, but rather what it isn’t. Microfinance institutions (MFIs) have only been around since the late seventies (we will cover their history in a later article), however before then, there were only banks. Banks existed in the developing world as much as the developed, however they failed to fight the surrounding poverty in some key areas. As a result, a niche in the market opened up for a new kind of financial institution, the MFI. The industry emerged with three abnormal characteristics, and if these are the first things you look at, it is likely you will become very confused, very quickly. As such, it’s worth being up front and laying these out in the open now.


Normal banks wouldn’t serve the poor because they had no collateral to weigh against the loan, as well as no income to pay it off. Hence, the microfinance industry came up with some unique ways to get around the issue, starting with high interest rates. Responsible MFIs charge interest between 10 and 40 percent APR – a rate unheard of in modern day banking. They also typically lend to groups of women more often than they lend to an individual. In other words, a loan of $500 to one lending group might actually be five separate loans of $100 a piece. Finally, MFIs will run complementary programs to support their borrowers. They do this in an active sense as part of the package. So, why is it that MFIs look so different from their banking counterparts in all of these ways?


The most obvious and startling figures are the high levels of interest. A small business association (SBA) loan in the US might range from 4 to 8 percent interest, while the profitable MFI, between 2003 and 2006, charged a median interest of 26 percent. We usually feel a sticker-shock when we see these numbers, but they can be deceiving. The problem is called cost of funds which is the interest rate the MFI has to pay to it’s funders. In other words, they have to cover the cost of lending money in the first place. This is not very costly in the developed world: most of your client’s information is available online and the size of your average SBA loan is between $150,000 and $500,000. Thus banks don’t have to charge high interest to make up the money they spent in disbursing it. However, if you’re giving out a $75 loan to a rural farmer in Bolivia for three months, a 4 percent interest rate will receive less than a dollar for your efforts. This won’t be enough to cover your cost of funds and the farmer is capable (and usually willing) to pay a few dollars more.


Although low-income households might have enough to cover the interest, they don’t always have the physical collateral to offer. Remember, banks wouldn’t lend to them for this reason, because if the client defaulted they would have nothing of value to take in exchange. What’s more, the threat of collateral inspired people to make their payments, so collateral had to be in place for the process to work. As a result, the MFI came up with something called social collateral. Social collateral is a phenomenon born from lending to groups instead of individuals. By giving a group of women joint liability over their debt, they could keep one another in check. If one had an emergency, the other four could chip in a little extra and cover her payment for the month. If another persona began defaulting, the rest of the group would pressure her to repay or else the entire group would receive a fee or lose eligibility for future loans. If the MFI couldn’t collect any physical collateral, they could at least manipulate social collateral to the same effect.


Group lending appears sound in theory, but the real life consequences aren’t so cut and dry. My organization had to drop group loans after two years, because we realized we were ripping the community apart. When someone’s neighbor didn’t repay, she and the rest of the group were liable and harassed the neighbor. Some of this was warranted when they weren’t repaying on purpose, but the overall effect was a negative impact on the community. We switched to individual loans, but this didn’t stop other groups from forming with other local MFIs. I would frequently hear complaints about a few specific people in the community who joined multiple groups and repaid on none of them. Others felt cheated because one member was eligible for a higher amount than they were. Luckily it never came to violence, but I can’t say the same for other community groups out there in the world.


Some of these differences hinge on social settings, but a number of issues also depend on how each member of the group runs their business. The third defining characteristic of an MFI is the menu of complementary services they offer the client. These programs are specifically to support loan use and repayment amongst the community and help them run their businesses. Whereas a bank might expect a client to have an education and good credit, a rag-picker in Bangladesh might have neither. Hence, MFIs offer training courses, business consulting services, and networking opportunities to assist low-income households in starting their business. This also ensures the MFI can influence the client to spend the money wisely.


We ran annual events, for example, where clients could come and learn about basic financial concepts that would help them in their every day lives. Our ‘Money Games’ allowed clients to practice keeping records of their sales and preparing for unexpected shocks to their income. At the same time, we did ‘Business Plan Competitions’, where competitors trained with us for an entire week to complete a template for their business idea. The winners with the best plans received the seed capital to start their venture.


In all fairness, there is still a lot in microfinance worthy of criticism. Many irresponsible MFIs will charge clients exorbitant interest rates as high as 400 percent, because their for-profit status got the better of them or they’re simply cheating their illiterate customers. Some lenders pit groups against each other and take physical collateral nonetheless. I knew a woman who lost all her weekly earnings, her stove, and five family TVs to an MFI before she could pay them off. In addition, too many MFIs worry about their bottom line and counting arrears rather than supporting their clients with additional services. We can’t say that microfinance is the silver bullet to end poverty, because we can’t say we know how to fully regulate its ethical boundaries. However, we do understand it as an industry that filled a void for the unbanked lower-income societies around the world. Its unique features are at least worth refining to better our grassroots lending initiatives.

About the Author

Jeff works on the ethical considerations of economic development and cash aid programs around the world. He currently works in Honduras, supporting local community projects through micro-finance and holds two degrees in Philosophy and International Affairs.

Discover the power of local community development

A place to learn about grassroots development in action



3 OF 9

This article is part of our free 'tools for economic development' course for local nonprofits




Essential to sound economic management is understanding local needs


Discover sustainable methods to leverage cash flow for social change


Discover the strategies you can use to promote sound economic managem



  • White Instagram Icon
  • White YouTube Icon
  • White Twitter Icon
  • White Facebook Icon


bottom of page