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written by | September 13, 2022

What is Microcredit? How Does it Work?

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What is microcredit? The term microcredit was coined by Nobel Prize-winning economist Muhammad Yunus and referred to small loans given to people in poverty who typically have no access to financial services or traditional banks. Here's everything you need to know about microcredit, including examples of how it works and its differences from other types of credit, such as microfinance and social credit.

Did you know? Microfinance provides financial services to persons who are not eligible for standard banking services. 

The Meaning of Microcredit

The term microcredit is used to refer to small loans which are provided to entrepreneurs, often with no or little collateral. The micro-credit programs are designed to assist people in starting or expanding their businesses and are an effective tool to aid in helping to alleviate poverty. These programs usually work by allowing the opportunity to access otherwise unavailable capital, as well as providing guidance and assistance to help the borrowers succeed. In most cases, microcredit loans are granted at interest rates less than the rates charged by traditional lenders.

Micro-credit schemes offer the majority of loans without collateral. A typical microfinance company offers loans with other products such as savings accounts and life insurance.

Microcredit programs typically offer flexible repayment plans, while most microfinance institutions' repayment period is one year.

Last but not the least, the main purpose of an average microfinance institution is training in business and education for potential borrowers, whereas, in the majority of cases, a microcredit plan aims to simply provide affordable capital for entrepreneurs who require it.

Also Read: Cash Credit Loan - Eligibility, Interest Rate, Features & Benefits

The Difference Between Microcredit and Microfinance

  • Definition of Microcredit

Microcredit is a credit facility offered to the poor and disadvantaged with extremely low incomes. The loan is given to those in a jobless state with no collateral and whose credit rating is not solid. The objective of the loan is to help people earn their income, particularly women who want to start their own business and establish themselves independently. Microcredit not only increases the income of the poor but also improves their standard of living. It offers financial aid for the very poor rural people to allow them to start their businesses instead of relying on loan sharks to raise funds, who charge outrageous interest rates.

  • Definition of Microfinance

Microfinance provides a broad range of monetary services to those in poorer income brackets who cannot take the banking assistance offered by banks and other services. It is offered to people who are extremely poor regardless of the location they reside in. Microfinance's purpose is to boost the earnings of poor people and allow them access to savings and loans. The customers could be pensioners, farmers, women, and others. Microfinance is a key element in the economy of any country. It assists the less fortunate in meeting their basic requirements and protects them from dangers. It increases the per-capita income. It promotes women's empowerment through providing long-term economic aid and thus promotes gender equality.

  • Microcredit can be described as a credit facility available to customers with low incomes. A variety of financial services for the less fortunate is microfinance.
  • Microcredit is an element of microfinance.
  • Microcredit is only a credit-based activity. Microfinance also includes credit and non-credit options like pensions, savings, insurance, etc.
  • Microcredit is a kind of microfinance that specifically refers to offering small loans to businesses and entrepreneurs. The loans for microcredit are usually smaller than ₹100,000. The word microcredit refers to the tiny size of the loan. Microcredit's concept can be that the most disadvantaged individuals can rise out of poverty with the opportunity to access financial assistance.

The World Bank estimates that nearly 70% of the world's population lives on less than $2 per day every year. Yet many don't have access to credit, making it impossible for them to start or expand their firms, send their kids to school or meet basic needs like food and health care. They don't have any collateral for banks to lend against or formal credit histories with which lenders might assess their riskiness as borrowers.

Also Read: Learn about Short Term Loans - Short Term Loan Period, Advances & Types

How Does Microcredit Work?

Microcredit works by providing small loans to people who might not otherwise have access to credit. This can help them start or expand a business, buy inventory, or cover other expenses. Micro-credit loans are typically given out by micro-credit schemes, which aim to provide financial services to the poor. Microcredit refers to the smaller size of these loans compared to traditional loans. One example is microfinance, which provides financial services to those with limited access to resources.

The structure of microcredit agreements often differs from conventional banking in which collateral might be necessary or other terms negotiated to ensure repayment. In some cases, the microcredit might have been backed by a contract with community members in which the borrower was located, which was expected to force the borrower to work towards paying back the loan. When borrowers complete their microcredits they might be qualified for loans with a larger and greater amount.

Strategies for Getting a Loan From an MFI

  1. Research the different microcredit institutions (MFIs) and their offerings. 
  2. Find an MFI that offers the type of loan you need. 
  3. If your loan is approved, sign the loan agreement and start making repayments according to the loan terms. 
  4. If not approved, try another MFI or look into other financing options. Ensure to go through all the contract terms before signing it, so there are no surprises later.
  5. If you have any questions about microcredit loans, talk to someone at your nearest MFIs or even ask them in person!
  6. Remember - getting a micro-credit loan from an MFI can be a great opportunity if done correctly!
  7. There are lots of modes to save money on interest rates, such as paying off high-interest debts first and saving more than 25% of income each month until you're eligible for loans again.
  8. When applying for a microcredit loan from an MFI, remember that borrowing money should be seen as a privilege rather than something everyone should do to improve their lives. 
  9. Furthermore, some argue that microcredit leads to exploitation because the lenders charge very high-interest rates, making the loans hard to pay. However, one could argue this is good because it prevents people from taking out more loans than they can afford to pay back since these rates discourage people from taking out unnecessary debt. 
  10. In conclusion, microcredit differs from traditional finance due to its focus on small businesses and entrepreneurship opportunities for individuals without access to banks and capital markets, giving them a chance for financial inclusion through access to credit services and improved livelihoods by using low-cost capital provided by MFIs.

How Does MFI Manage Risks in Lending Operations?

There are several ways that microfinance institutions (MFIs) manage risks in their lending operations. One way is to screen borrowers carefully before making a loan. This includes looking at the borrower's income, expenses, and debts to ensure they can afford the loan payments. MFIs also typically require collateral for loans, which gives them something to fall back on if the borrower defaults. They may also spread out their loans to different borrowers so that no one borrower represents too large a portion of their portfolio. MFIs might also diversify their investments by spreading money into other assets, such as bonds or stocks.

The notion of risk is at the foundation of all financial intermediation.

Also Read: Top Business Loans for Women in India - A List of Small Business Loans for Women

Systematic Risks

The systemic risks that confront the entire industry, including rainfall-related failures, can simultaneously affect many customers' lives. They aren't removed, but they can be reduced by buying insurance on a portfolio basis or diversifying across various regions. However, a major systematic risk that has become apparent in recent years and has affected MFIs significantly is the risk of political instability.

Idiosyncratic Risks

These risks can be internalized in the organisation and include the risk of credit and operations. In microfinance, both are closely interconnected and could be one of the major reasons MFIs fail.

Operational Risks

Microfinance is a model that relies on operations, and inefficient processes can affect internal control, resulting in fraudulent activities and other operational errors. Accurate mapping of the process and sub-processes can help MFIs identify risk and the weak links that could pose the greatest risk of fraud. To spot fraud before it is too late and to take appropriate action, MFIs should have a risk-scoring model that assigns each branch a risk score. Branches with a history of fraud need to be penalised in the risk scoring model, and the frequency of audits related to an overall risk score. This can help to answer two crucial questions: Which branch is bad portfolio management? Is the branch the scene of fraud?

Cash Movement

Because most MFI collections and disbursements are based on cash, institutions risk losing cash. This is particularly true for institutions that operate in remote areas if cash movements are not monitored and checked against the collection and demand the risk of fraud.

The risk of fraud is reduced by MFIs setting cash-retention levels for branches and any deviations being approved and documented. The reconciliation of cash using MIS within branch banks is essential in examining idle and float cash at every level. The risk of burglary in cash movement is mitigated through the insurance of cash-in-transit, branch and cash-in-safe and assurance of fidelity.

Interest Rate Volatility

Interest rate volatility is one of the most significant dangers MFIs have to deal with. The changes in the interest rates they borrow affect spreads, particularly in the short term. The majority of MFIs do not specifically control the risk of interest rates. The rising cost of funds is a major drag on margins, which can negatively impact the profitability of operations and self-sufficiency.

Like every other financial institution, managing risk is crucial to the performance of MFIs. The unique circumstances of MFI operations, which involve underwriting by clients' groups and handling large quantities of cash that are not deposited in branch locations, require specific risk management requirements. MFI boards, as well as lenders and investors, must be aware of these characteristics.

Also Read: What is Working Capital Loan? Meaning, Types, Advantages, Examples

Conclusion:

In conclusion, microcredit is a tool that can be used to help alleviate poverty. A microloan is a very small loan given to people who do not have a steady source of income, collateral, or credit history. A small business or idea can't be capitalised on without financial backing, so this program supports and kickstarts entrepreneurs who don't have access to it. As always, do your research and ensure you understand all the ins and outs before making any decisions.

Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: What's a Microcredit Quizlet?

Ans:

The microcredit program is a programme which provides loans of a small amount to the poor, especially women, to facilitate the development of small-scale companies.

Q: What can microcredit do to help the less fortunate?

Ans:

The concept was straightforward enough: providing a small amount of money to a person living in a low-income country could allow them to grow their small business, which could lift their family from poverty. Once they've paid to repay the loan, it can be distributed to additional people who are borrowers, lifting additional families from poverty.

Q: Why is microcredit vital?

Ans:

The benefits of microfinance are small loans allow entrepreneurs to establish or expand their micro, small, and medium businesses. Savings can help families accumulate assets to fund the cost of school, upgrade their homes, e.g. install electricity or water running) and reach their goals.

Q: What are the advantages of microcredit?

Ans:

Microcredit alleviates a binding credit limit, enabling efficient resource allocation, decreasing inefficiency, increasing productivity and income, and decreasing the rate of poverty.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.