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What is microfinance?

Microfinance is the provision of financial services to low-income people. It refers to a movement that envisions a world where low-income households have permanent access to high-quality and affordable financial services to finance income-producing activities, build assets, stabilize consumption, and protect against risks. Initially the term was closely associated with microcredit—very small loans to unsalaried borrowers with little or no collateral—but the term has since evolved to include a range of financial products, such as savings, insurance, payments, and remittances.

Microfinance institutions and other financial service providers have worked over the past decades to develop products and delivery methods to meet the diverse financial needs of low-income people. For example, unlike other forms of lending, microcredit loans use methodologies such as group lending and liability, pre-loan savings requirements, and the gradually increase in loan sizes to evaluate clients’ credit worthiness. Microfinance providers today continue to improve their understanding of the financial needs of their target clients and tailor their products and methodologies accordingly.

Who are microfinance clients?

Typical microfinance clients have low incomes and are often self-employed in the informal economy, conditions that together typically deny them access to banks and other formal financial institutions. They commonly run small stores or street stalls, create and sell items they make in their homes, and in rural areas, microfinance clients may be small-scale farmers and those who process or trade crops and goods.

Microfinance clients are often just below or above the poverty line, commonly defined as earnings of US$1.25 a day, and women constitute a majority of borrowers. Over the past decades, financial institutions have been developing a range of products to meet the diverse needs of this broad and underserved market.

 

Why are interest rates higher in microfinance loans than in traditional banking?

Small loans are more expensive to process than large ones because they take longer to process. Without employment history or collateral, microfinance loans require a more hands-on, time-intensive assessment to determine creditworthiness. Microfinance institutions (MFIs) usually send a representative to visit the client as part of this process, making the process even more challenging and costly in remote or sparsely populated areas. Once a loan is approved, MFIs often send loan officers to disburse loans and collect payments in person, which also adds significant expense when compared with the way traditional banks operate. MFIs have to charge rates that are higher than normal banking rates to cover their costs and keep the service available.

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