External sources of finance come from outside the business. Microfinance belongs to external sources of finance. When businesses need to use the money for a short period of time (less than one year), this creates the need for short-term finance.
5. Microfinance
Microfinance is providing financial services such as bank loans and overdrafts to low-income customers. Small amounts of money are loaned to entrepreneurs in countries where business finance is difficult to obtain.
Who uses microfinance?
These small capital sums become a very important source of finance for entrepreneurs to help start up their businesses.
Firstly, entrepreneurs from poor backgrounds in developing countries without access to regular banking services offered by traditional commercial banks. They do not have any savings or rich family members and friends who could loan them the money. Hence, banks and other lenders consider them as too risky.
Secondly, many women in some Asian and African countries receive microfinance. Females in traditional societies very often find it difficult to obtain loans or access banking services at traditional banks.
How did microfinance start?
Muhammad Yunus, an economics lecturer at University of Chittagong in Bangladesh had been lending small amounts of money to poor villagers. With those small amounts of capital, they not only managed to start their businesses, but also repaid their loans in full.
In 1980s, Muhammad Yunus has founded Grameen Bank. The bank specializes in lending small amounts of money to poor people with no bank accounts and who are unable to obtain finance from traditional sources to set up their own very small enterprises.
Benefits of microfinance
- Stimulates entrepreneurship. Entrepreneurship in the form of many small companies operating on the market is greater in regions with microfinance schemes being available.
- Improves living standards. Entrepreneurs who work for themselves are able to earn money, therefore the average incomes are rising thanks to more successful businesses.
Drawbacks of microfinance
- High interest rates. Because microfinance loans are quite small, interest rates on those loans and other administrative costs might be quite high. According to Kiva.org, an organization founded in San Francisco in 2005 to provide crowdfunded microloans to underserved individuals globally, the average global interest rate charged on microloans is about 35%.
- Exploitation of the poor. Very poor people without much power might be forced to take on high-interest debts which they will never be able to repay. This will put them in even more disadvantaged position socially.
More details about microfinance loans
The microfinance loans are usually for very small amounts. They are also typically repaid after a relatively short period of time within six months to a year. Once the loan has been repaid, it then becomes available to other borrowers.
