The Top Pros and Cons of Microlending for Business Owners
Since then, the microlending definition has transformed. Today, small business owners and entrepreneurs in developed countries also use microloans to finance their ventures. In the United States, the Small Business Administration (SBA) defines a microloan as any loan with less than $50,000.
Unlike Grameen Bank, SBA lender’s microloans come in at an average amount of $14,434.
While $14,000 may seem small to established businesses, it can be game-changing for new entrepreneurs. Given the potential benefits microlending might provide for your business, it’s worth a closer look. In this post, we’ll review how microlending works and the pros and cons of this funding option.
What is Microlending, and How Does it Work?
In terms of structure, microlending works similarly to a typical term loan. The lender evaluates the borrower’s application, provides approval status, and offers a loan with specific terms and conditions. Assuming the loan is accepted, the borrower pays it back with interest based on an agreed-upon payment schedule.
Just like a traditional business loan, microloans may carry fees and penalties. Microlending is distinct from traditional lending in that it involves smaller loan amounts. Also, the lenders and borrowers participating in microlending are often individuals, nonprofits, and alternative lenders. Unlike traditional lending, microlending isn’t dominated by banks and credit unions.
Many microloans are made through peer-to-peer (P2P) lending platforms. On these platforms, many individuals come together to invest small amounts of capital into many different loans. If you get a microloan from a P2P platform, the money from that loan likely comes from several individual investors.
What Are the Pros and Cons of Microlending?
The Pros of Microlending
1. More Lenient Qualification Criteria
Qualification criteria vary by lender, but it’s generally less stringent for microloans than traditional loans. You should still expect to be asked for personal and business financial information. Also, most lenders, including SBA lenders, will require a personal guarantee and collateral.
Fortunately, with a low average loan amount, the collateral you need for microlending doesn’t need to be extremely valuable. For example, if your collateral must be worth 80 percent of your loan amount of $10,000, it only must be worth $8000.
2. Wide Variety of Available Uses
Microloans are like general commercial loans in terms of how you can use the loan. For example, with the SBA’s Microloan program, borrowers can use loan funds for expenses such as:
- Working capital
Of course, restrictions on using funds may vary by lender, so double-check on any microloans you consider.
3. Diverse Lender Options
While not all lenders offer microloans, you can find microloans from many different types of financial institutions, such as:
- Alternative lenders
- Traditional banks and credit unions
- Government agencies
- Peer-to-peer lending platforms
Each lender type has pros and cons, but the sheer number of options is one of the microloan’s advantages.
The Cons of Microlending
1. Small Loan Amounts
Depending on the maturity level of your business, microloans may be too small for your needs. While the SBA technically allows for loan amounts up to $50,000, microloans of this size are hard to secure.
SBA microloans over $20,000 are only allowed if the borrower can’t obtain credit elsewhere at comparable rates and shows they have “good prospects for success.”
Generally, SBA lenders provide the largest microloans. Therefore, if you’re looking for a larger loan, you may want to consider a traditional business loan.
2. Potentially Higher Interest Rates
Microloans don’t always have high-interest rates but do when the borrower has a bad credit score. Investopedia notes that on the microlending platform Prosper.com, the best-rated borrowers can expect to pay a minimum annual rate of 6 percent. On the other hand, the riskiest borrowers may pay as much as 31.9 percent on Prosper.
Again, high-interest rates aren’t a guarantee on microloans. In addition to your credit rating, the type of microlender matters too. For example, the SBA’s average interest rate on microloans in 2020 was 6.5 percent, which is very competitive.
3. Lack of Availability in Some Areas
While it’s certainly growing, microlending hasn’t yet hit the mainstream financing market. Because of this, there are some areas of the country where microlenders are harder to find. So, before you get too excited about a microloan, make sure they’re available near you. To find lenders participating in the SBA Microloan Program, use this search tool from the SBA.
Is Microlending Right for Your Business?
If you know you need a small business loan but only require a small amount of money, microlending is worth considering. Yet even then, you should consider alternatives.
Merchant cash advances, invoice factoring, equipment financing, business credit cards, and more may be viable financing options. To determine if microlending is right for you, compare the costs and benefits of all your alternatives. The option that fits your business’s needs best and meets your budgetary constraints is the one that’s right for you.
Editor’s Note: This post was updated for accuracy and comprehensiveness in February 2021.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.