An extremely small loan given to those who do not have a steady source of income, collateral, or any credit history
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What is Microcredit?
Microcredit is an extremely small loan given to those who lack a steady source of income, collateral, or any credit history. It aims to support and kickstart entrepreneurs who are unable to obtain the financial backing needed to start a small business or capitalize on an idea.
It is also more common in underdeveloped countries, as it is aimed to support people of a lower socioeconomic background. Individuals who receive a microcredit loan may be illiterate; thus, they are unable to apply for conventional loans due to the paperwork involved.
Microcredit is also part of microfinance, a line of finance that aims to help people of a lower socioeconomic background through catered financial services, which include savings accounts and loans.
It is said to be originated in 1983 by the Grameen Bank in Bangladesh, with the idea coming from economist Muhammad Yunus. More recently, it’s been used as a tool to hopefully decrease the increasing wealth gap.
History of Microcredit
Though the term microcredit is relatively new as it was invented in 1983, the concept is to provide financial help to those of a lower socioeconomic background. It is said that lending to people of lower socioeconomic background goes as far back as the 1700s in Ireland.
However, a new vision on the delivery of microcredit was introduced from the 1970s to the 1980s, and Muhammad Yunus was a key player in shaping the vision. He decided to open Grameen Bank in 1983 and realize his vision. Grameen Bank was able to receive funding and created a microcredit model.
One of the first examples of microcredit originated from a group of women who created bamboo stools in Bangladesh. The women were earning a minimal profit of $0.02 on each stool due to the repayment of suppliers.
Muhammad thought that if the women were provided with a source of credit to draw from to fulfill payments to suppliers, the women could make it out of poverty. The women were loaned $27 and were able to sustain the business and pay the loan off.
How does Microcredit Work?
Microcredit was built on the concept that people with skills and more entrepreneurial mindsets also came from impoverished countries that did not necessarily have access to financial services that could suit them.
People who receive microcredit services typically live on a barter system, where goods or services are exchanged for other goods or services, and currency is not used as a medium for exchange.
The modern concept of microcredit is based on the Grameen Bank model, where loans range from $10 to $2,000. Microcredit loans may not include any written contracts, and repayment starts immediately. As people pay off microcredit loans, they gain credit and can take out more loans.
Microcredit loans may also charge interest, and some loans may include a covenant to set aside a portion of income in a savings account as a form of collateral. If the loan is repaid, the full amount in the savings account is available.
Cons of Microcredit
There are some cons regarding microcredit, including too much pressure to repay loans, a large suicide rate among borrowers, and severe debt levels.
A contributing factor to the disadvantages is the high interest rates on some microcredit loans – rates can be 30% or even higher. Some even compare microcredit loans to loan sharks or NINJA loans, which actively take advantage of impoverished individuals.
Related Readings
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
