How They Work

• The basic idea behind microloans is that in poor areas and countries, individuals do not have access to regular banking processes. They cannot simply walk into a bank and borrow $25 or $50, even though borrowing this amount of money might help them significantly. With a microfinance lending institution, these poor individuals can gain access to small loans and then repay them at some point in the future when they earn enough money to do so.
  
  

Purpose

• The purpose of a microloan is often to help very small businesses grow or stay in operation. For example, a local farmer may need to buy another goat or a cow and not have the money necessary to do it. By borrowing the money, he can make the purchase and then earn money in the future. At that point, the farmer can repay the amount he borrowed and continue growing his business over the long term.
  
  

Problems

• One of the problems with microloans is the very high interest rates these lenders often charge. In some cases, lenders have to charge 60 percent interest or more to cover the costs of travelling to remote areas and making the loans. A study by Dean Karlan and Jonathan Zinman showed that recipients of these loans did not typically grow their businesses. In fact, recipients of the loans were more likely to have their businesses stay the same size or shrink.
  
  

Benefits

• Although the study did show that many businesses were likely to shrink or stay the same, it also showed that the recipients of these loans were more likely to be able to handle short-term risk. They used the money as an emergency fund and they were able to deal with financial emergencies and problems as they came up. This ultimately led them to develop relationships with other lenders and helped them stay in the community longer.