A micro credit is a small loan to people with a low income. The size of the loan may vary from fifteen Euro (in India for example) to a few thousand Euro’s (in Eastern Europe and Latin America). The loan is used for small scale economic activities like small trade, services as bicycle repair and hairdressing, agricultural activities, livestock, bars and restaurants and small scale production.
Microfinance is the full range of financial services to poor people. Like anyone else, people living in poverty need financial services to run a business, to create reserves for unexpected expenses and shield themselves against risks. Apart from loans, microfinance also comprises savings, micro-insurance, micro-lease and money transfer services.
Low income people usually can’t access loans from the formal financial sector. Bank branches are far away, banks ask for physical collateral that poor people don’t have, poor people have difficulties in filling in the complex forms or bank employees do not believe in the creditworthiness of poor people, do not take them seriously. A bank considers the risks of lending to poor people just too high. Furthermore, poor people can not save with commercial banks because their deposits are small and considered too expensive to collect.
A Micro Finance Institution (MFI) is an organisation that provides financial services to low income people. These institutions take into account their conditions and possibilities. Staff goes often to their clients places, helps with filling in simple forms, does not ask for physical collateral as much as possible and takes clients very seriously.
Some 97 to 99% of loans from well performing MFIs are repaid. Poor people are dedicated to repay their loans on time because they have only a very few appropriate possibilities to access loans elsewhere and good repayment is conditional to obtain successive loans. Furthermore, MFIs use social pressure: loans are provided to individuals who organise themselves in groups. If one group member does not repay, the others have to repay for him or her and recover the debt later on from the defaulter. Moreover, the financial discipline of clients is tested at the beginning. During a couple of weeks or months clients have to save small amounts to demonstrate their capacity to put money aside. Finally, repayment schedules are being adapted to the client’s possibilities, often resulting in small amounts to be repaid over several months. This reduces the risk for defaults
Worldwide an estimated 75% of microfinance clients is female. In many countries women have their own economic activities for which they need financial services. Experiences have shown that women, every where in the world, repay better than men. Furthermore, in general, a woman’s income benefits more the household and family than a man’s income, who spends it more often on personal things: going to a bar or taking a second wife. Finally, several organisations target only women for reasons of empowerment: micro credit is being used as an instrument for economic independence, decision making power and self confidence and self respect of women.
Worldwide people save. Poor people even have more reasons to save to create reserves because they are never sure of a future income. In some case they only save very small amounts, such as 25 cents a week. Mostly people save in informal ways: they invest in assets such as gold, livestock, building materials and other things that can be easily exchanged for cash. Or part of a harvest is put aside and sold in case of a need for cash. People also save money at home or burry cash in the garden. But all these saving methods have their limitations: cash at home can be stolen, eaten by mice or insects, burned or claimed by relatives or friends who are difficult to refuse. It is not possible to cut a leg off a goat and sell it in case of a need for a small amount of cash. Money saved with a Microfinance Institution is safe and often also generates a (small) interest.
To maintain and increase its services over time, an MFI must charge interest rates high enough to cover the cost of its loans.
There are three kinds of costs the MFI has to cover when it makes micro loans. The first two, the cost of the money that it lends and the cost of loan defaults, are proportional to the amount lent. For instance, if the cost paid by the MFI for the money it lends is 10%, and it experiences defaults of 1% of the amount lent, then these two costs will total €11 for a loan of €100, and €55 for a loan of €500. An interest rate of 11% of the loan amount thus covers both these costs for either loan.
The third type of cost, transaction costs, is not proportional to the amount lent. The transaction cost of the € 500 loan is not much different from the transaction cost of the € 100 loan. Both loans require roughly the same amount of staff time for meeting with the borrower to appraise the loan, processing the loan disbursement and repayments, and follow-up monitoring. Suppose that the transaction cost is € 25 per loan and that the loans are for one year. To break even on the € 500 loan, the MFI would need to collect interest of € 50 + € 5 + € 25 = € 80, which represents an annual interest rate of 16%. To break even on the € 100 loan, the MFI would need to collect interest of € 10 + € 1 + € 25 = € 36, which is an interest rate of 36%. At first glance, a rate this high looks abusive to many people, especially when the clients are poor. But in fact, this interest rate simply reflects the basic reality that when loan sizes get very small, transaction costs loom larger because these costs can’t be cut below certain minimums. And informal money lenders and people’s own savings and loans groups often ask even much higher rates.
Sometimes it does, but most often not. Old or sick people need other forms of help than a small loan. And some people live in such a predominating poverty that they would use a loan to satisfy their basic needs and thus risk to getting into a debt trap. In these cases an integrated support package in the fields of health, housing, education and employment, might be more appropriate.
Many MFIs target only the "active" or "productive" poor, people already running an economic activity. Those who do not, are thus excluded.
Finally, credit programmes for poor people often ask people to form a group and guarantee each others loan. The poorest of the poor are sometimes excluded by others or lack social contacts or self confidence to form a group themselves.
But in certain cases successful programmes have been developed for the (almost) poorest of the poor, with loans of only some € 10.
Poor people, with access to savings, credit, insurance, and other financial services, are more resilient and better able to cope with the everyday crises they face. With access to micro-insurance, poor people can cope with sudden increased expenses associated with death, serious illness, and loss of assets.
Access to credit, however small, allows poor people to take advantage of economic opportunities. By reducing vulnerability and increasing earnings and savings, financial services allow poor households to make the transformation from "every-day survival" to "planning for the future." Microfinance contributes to improved living conditions, better nutrition, better housing, more children going to school, more self esteem and self respect and less domestic violence.