Docstoc

Microloans: What They Are and How to Use Them

Microloans average in size of $13,000 and are used to start-up or bridge small businesses with little if no credit history.

What is a Microloan

Microloans originated in Bangladesh as a way to fight poverty. They work exactly like the old adage, “Don’t give a starving man a fish. Give him a fishing pole.” Most of us think of microloans in this way. An extremely popular website called Kiva allows individuals to make loans to poverty stricken entrepreneurs in developing countries for as little as $25. These funds can be used by the borrower to buy things such as livestock or seed and start a sustainable journey towards economic stability. In some places around the globe, just $25 is all it takes to jumpstart a small venture, hence the term “microloan”.

The concept has emigrated to the US and other developed economies. Organizations like the Small Business Administration (US) help borrowers with either no credit, a bad credit history, or some other limitation, get access to lenders. The loan amounts are less than $50,000 and the average is $13,000. The idea is to promote healthy entrepreneurship with lower income individuals whom might not have otherwise had access to business funding.

Who should get a microloan?

Ideally, microloans are intended to jumpstart small businesses with little or no founder’s capital. They can also be used as infusion capital for expansion or working capital to help grow a small business with a short history or little cash flow.

Imagine a certified hairstylist with years of experience who believes she could open a salon for $20,000. She has a few thousand dollars of her own to contribute and owns a car to pledge as collateral. However, she has very little credit, having never used credit cards. A microloan might be the perfect solution.

Contrary, if you are already in business, have good credit and collateral, and you have healthy cash flow, then a traditional small business loan from a commercial bank is probably right for you. There would be less underwriting requirements, you can obtain more than $50,000, and your options for lenders will be greater.

Requirements

Certified training and experience in your field of venture is highly recommended, if not required. Expect most lenders to require at least two years experience. Additional training on operating a business might also be required if the borrower has no proven history of managing a business. A written business plan is always required.

Advantages of a microloan

Availability is the biggest advantage. Traditional small business loans from a bank can be extremely difficult to secure for a start-up or young business. Microloan programs are administered at a local level so they are actionable and accessible. They are administered by not for profit agencies whose mission is to boost economic activity.

Being required to take classes on how to run a business might seem like a distraction, especially if you have considerable experience in your field. However, look at the classes as an opportunity rather than a distraction. They are intended as a measure to help ensure payback of the loan, i.e. they are intended to help you succeed.

Disadvantages

The cap amount on microloans makes them insufficient to cover start-up costs for many types of ventures. Given that the average microloan is $13,000, you can see that they are indeed meant for very small businesses with limited capital requirements.

The small cap amount makes use of the funds a challenging argument. Many business experts would caution against using microloan proceeds to fund operating expenses. Long-term debt financing is traditionally used by businesses for expansion, not operation. Going back to our salon owner example who needed $20,000 in start-up funding. Suppose she was underwritten for $15,000 and could make up the difference with savings, $5,000. This would give her $15,000 to outfit a space, decorate, and buy equipment. Operating expenses like rent and advertising should come out of her savings.

Other Options

This isn’t a personal finance article, this is a business article. Most businesses are going to have to borrow money at some point, and business borrowing habits are different than personal. That is why credit cards can be a great alternative to microloans.

What if our salon owner had $5,000 in savings and a credit limit of $15,000 on a credit card? In this case I would recommend her to take less on the microloan and use her credit card to make some of the capital purchases like salon chairs and equipment. Credit card repayment terms are extremely flexible. Microloan repayment terms will be fixed and certain months cash will be tight. If the microloan repayment is too expensive during these months, then default could occur. By having a mix of credit card and microloan debt, the salon owner could pay the lower monthly microloan payment and what’s left over can go towards the credit card.

Sources

Small Business Administration

SBA Loans 1-2-3