Business Banking

What is a microloan?

At some point many business owners must consider different lending options available to them. In our article we discuss the pros and cons of microloans & if microlending is right for your business.

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One reality of running a business – whether large or small – is that at some point you may need external capital injection. This typically comes in the form of a loan. But for small businesses, traditional bank loans are not easy to come by, especially for amounts under $200,000.

Traditional lLenders often impose strict eligibility requirements, particularly around creditworthiness, revenue and years in business. It’s no surprise that only 48% of small businesses in the U.S. get the financing they need1.

However, with the growth of microlending, microloans are now filling some of the gaps for entrepreneurs who cannot access conventional small business loans. Despite their small amounts, oftentimes microloans are exactly what small business owners need. They serve as lifesavers for many scenarios, from meeting payroll needs to filling cash flow gaps in times of emergencies like the coronavirus pandemic.

The important question is: what is a microloan? Is it the right type of loan for your small business? How do you qualify and apply for one? Here’s everything you need to know.

Key takeaways

  • A microloan is a small loan of $50,000 or less with a low interest rate.
  • There are three main providers of microloans: the SBA, nonprofit organizations, and peer-to-peer lenders.
  • As is the case with all other types of loans, microloans have to be paid back. Some microloans are interest-free, which means you only repay the principal amount.
  • The main benefit of microloans is that they are more affordable and accessible to small business owners compared to traditional bank term loans.
  • Despite their many advantages, microloans carry small amounts, which can be a turn off to business owners who desire larger loan amounts. They also typically require extensive documentation and take a while to process.
  • To get approved for a business microloan make sure that you meet the lender’s requirements, create a business plan, collect all the required documentation and complete the application process online.

What is a microloan?

Generally, microloans are small business loans that max out at $50,000. They are typically offered by government agencies, nonprofit organizations and individual lenders.

Many traditional banking institutions do not offershun microloans because they are not profitable since they are expensive to create owing to their high fixed costs relative to loan amount2. But individual lenders, government agencies and the nonprofit community do not have the same profit motiveoverhead costs as conventional lenders. This allows them to generate microloans without having to worry about costs.

While any type of business can use a microloan, it’s generally favored by low-income small businesses and startups that lack the credit history and revenue requirements for accessing traditional loans. Some microlenders specifically focus on underserved groups such as women and minorities.

Although some microloan programs specify how you can use the proceeds of the loan, others give you the freedomfree will to decide, as long as it is used for business purposes. You can spend the funds on working capital, purchasing equipment, acquiring inventory, funding seasonal expenses, meeting emergency cash flow needs etc. Some microloan programs go a step further to offer assistance with financial counseling, training and marketing to help new entrepreneurs in their self-employment journey.

How does microlending work?

Microloans work more or less like traditional loans. After a successful loan application, the microlender gives you a lump sum that you have to pay back with interest over a set period of time. You can make weekly, biweekly or monthly payments; it depends on your agreement with the lender.

Microloan programs are available from various institutions, including:

  • The U.S. Department of Agriculture (USDA),
  • U.S. Small Business Administration (SBA),
  • Nonprofit organizations such as Accion, and
  • Peer-to-peer financiers like SoLo Funds., and

There are also some alternative lenders who provide microloans packaged as short-term small business loans that max out at $50,000. These too are worth a second look at, more so if your business is strapped for cash or has an emergency expense.

But keep in mind that most alternative lenders generally charge a higher-than-average interest rate. So, it’s best to only use them as a last resort, especially since some microlenders like Kiva have interest-free loan options.

That said, not every loan program that’s provided by microlending financial institutions is interest-free. Many of them have interest rates that vary from lender to lender. Similarly, microloan repayment terms often differ between financial institutions. But you can expect a maturity period of three to six years, depending on the loan amount.

Do you have to pay back microloans?

Yes, borrowers of microloans are typically required to pay back the loan, including interest. However, these loans are generally less strict compared to other financing options like term loans. You may easily get a low interest rate and maturity period of three to six years. These relaxed repayment terms make microloans significantly more attractive to entrepreneurs and small business owners.

While microloan interest rates vary from lender to lender and depending on the amount borrowed, they typically range between 5% and 20%. The rate that you get – along with the loan amount, lender’s repayment terms, and maturity period – ultimately determines your monthly payments.

Benefits and drawbacks of microloans

Like every other type of loan for small businesses, microloans come with advantages and disadvantages. Their biggest draw is that they are more accessible and affordable compared to other sources of business financing. On the other hand, the amount of money is far less than what you can get from other financial institutions. With that in mind, below are the main benefits and drawbacks of microlending:

Pros of microloans

  • Relaxed lending terms. Microlenders, by and large, do not have strict eligibility requirements. New companies with no years in business can qualify and get approved for microloans. Similarly, some microlenders like Kiva do not have credit score requirements. Others like Grameen America target women who have bad credit. Such relaxed lending terms allow entrepreneurs to access credit when they would otherwise have been turned down by banks and other traditional financial institutions.
  • Serve the underserved. Microloans offer viable financing options for groups that are often locked out of traditional bank loans. This is particularly the case with microloan programs that target borrowers who are often denied traditional bank loans, be it for bad credit, low revenue or insufficient time in business. Some microlenders only work with specific groups, such as veterans, women, people with disabilities or minorities.  
  • Can help entrepreneurs and businesses build credit. Since many microlenders report borrowers’ activities to credit bureaus2, they can help businesses and their owners to establish and build credit. This is especially the case if you regularly make on-time monthly payments.
  • Short time to funding. Getting a traditional bank loan typically takes three to six weeks – sometimes even longer3. With a microloan, once your application is approved, you’ll have the money in your business bank account within a few days. Microloans from alternative lenders take even shorter; at times a day or less because they use streamlined lending procedures. That said, SBA microloans can take up to 90 days.
  • Additional services. A good number of microloan lenders offer “after-sale service” with their credit products. You may receive counseling, training, marketing or financial management advice along with your microloan.

Cons of microloans

  • Low limits. Microloans have a borrowing limit of $50,000. While it may be suitable for certain expenses like utilities and payroll, this amount of money can be quite small for capital investments. Keep in mind that $50,000 is the maximum limit. Most businesses don’t get approved for the maximum. In fact, the U.S. Small Business Administration (SBA) grants an average of $13,0004. To get a larger loan, you may still have to check with banks and credit unions.
  • Collateral may be required. It’s not uncommon for a microlender to ask for collateral or a personal guarantee. This is because microloans are often used by borrowers with a checkered credit history.
  • Can temporarily lower credit score. If a microlender runs a hard credit check on you, the result may be a temporary dip in your credit score. This is the case with all hard credit inquiries. But if you manage the resultant debt diligently, your credit score will improve. Make sure to regularly pull your credit report and check how the microloan is performing as a tradeline.

Types of microlenders

There are three main microloan providers: the U.S. Small Business Administration (SBA), nonprofit organizations, and peer-to-peer platforms. Understanding how these microloan lenders work can help you choose the right type of loan and creditor.

SBA microlenders

The SBA microloan program gives money to designated nonprofit organizations and intermediary lenders, who then extend loans to low-income, women, minority and veteran entrepreneurs. These are essentially business owners who are often sidelined by traditional lenders. Beyond that, the SBA microloan program also caters for nonprofit childcare centers.

The SBA loan, under the microloan program, maxes out at $50,000, with the average borrower getting about $13,0004. The maximum term for an SBA microloan is six years. There aren’t many restrictions on how you can use the proceeds. Thus, you can use this SBA loan for inventory, supplies, working capital, equipment, fixtures etc.

The two things you can’t do with the SBA microloan are paying off an existing debt and purchasing real estate. Other than those two, you can use the loan amount for pretty much anything else.

Unlike most other types of SBA loans, SBA microloans have fairly relaxed eligibility requirements. Qualification requirements include:

  • Your company must be officially registered as a for-profit business
  • You must have invested your own time and money in the business prior to applying for the SBA microloan.
  • The company should be a small business as defined by the SBA. This means it should have fewer than 500 employees, earn under $7.5 million in annual revenue, and have a net worth of under $15 million.
  • You must have tried and exhausted all other business financing options.
  • The company should be physically located and operated within the U.S.
  • You must have a clear financial history that’s free of defaults, bankruptcies and debts owed to the federal government.

It’s worth mentioning that intermediary lenders often have their own eligibility requirements in addition to those set by the SBA. For example, you may find it very hard to get approved for an SBA microloan if your credit score is below 6205.

The SBA doesn’t charge origination fees for microloans. However, most intermediary lenders do. You can expect to pay an origination fee of up to 2% of the loan amount. Additionally, the lender may charge an application fee, credit check fee to pull your credit report, and loan closing costs.

Although intermediary lenders of SBA microloans are free to set their own interest rates based on factors like loan amount, credit score, and repayment term, the SBA usually caps the maximum interest rate that lenders can charge. This typically ranges between 8% and 13%.

Nonprofit microlenders

Some microlenders create microloans themselves rather than acting as intermediary lenders for SBA loans. These are usually mission-driven lenders who aim to support specific minority and underserved groups in the society.

For example, the Accion Opportunity Fund serves low-income entrepreneurs, people of color, LGBTQ, immigrants, veterans, women, and business owners in industries that are considered too risky. All these groups generally struggle to get the financing they need to start and run businesses. If you fall in any of the aforementioned groups, you may qualify for an Accion microloan or even a larger loan of up to $100,000.

Some microlending organizations work exclusively with minority groups in specific regions of the U.S. A good example is the Business Center for New Americans (BCNA), which provides microloans to New York-based small businesses that are owned by refugees and immigrants.

Something to keep in mind is that some microlenders in the nonprofit community are, in fact, Community Development Financial Institutions (CDFIs). This means they maintain CDFI certification, which puts them under any of the following categories:

  • Community development loan funds
  • Community development banks
  • Community development credit unions
  • Community development venture capital funds

Some nonprofit microlenders that commit to CDFI principles include Accion Opportunity Fund, LiftFund, and Grameen America.

Peer-to-peer microlenders

There are microlenders that use the peer-to-peer method of lending. Like other peer-to-peer (P2P) lending platforms, these microlenders connect business owners with individuals who are willing and able to grant small business loans. These investors get a portion of the interest paid by loan borrowersborroers.

In a P2P setup, there are no financial institutions acting as middlemen. The P2P platform simply matches borrowers with investors, who usually have relaxed qualification requirements. Many of them won’t ask for a good credit score or several years in business. This makes P2P platforms ideal for startups that haven’t had enough time to build business credit.

Similarly, you may turn to peer-to-peer microlending if your personal credit is less than good. However, make sure to read the platform’s terms and conditions before committing to taking out a microloan. Some may have unreasonably high interest rates.

A few examples of peer-to-peer microlending platforms are:

LendingClub: has a solid track record of helping entrepreneurs to secure business credit. The fast and easy application process is a plus. And they don’t run a hard credit check when you apply, which is good news for your credit report.

  • Kiva: with the mission to serve low-income, underserved and unbanked business owners, Kiva offers a platform where lenders can provide business credit to entrepreneurs who can’t access traditional bank loans. The biggest draw to Kiva is that its loans are completely interest-free.
  • SoLo Funds: SoLo is a big name in the nonprofit community because of its affordable loans. It lets borrowers specify the terms they want in a loan, and then willing lenders extend the financing based on those terms. The fact that SoLo interest rates don’t compound makes it that more appealing to low-income business owners.

Common use cases for microloans

Apart from “what is a microloan?”, a question that many entrepreneurs often ask is: what type of business can use a microloan? In the grand scheme of things, any business can use a microloan. However, its small amount of money makes this type of loan more suitable for startups and small businesses that run on fairly little capital. A microloan may be good for your business if:

  • The business needs a capital injection of no more than $50,000. Granted, some microloan lenders like Accion can grant a larger loan amount (up to $100,000), but that’s extremely rare.
  • You have a bad credit history that bars you from accessing a traditional bank loan.
  • The business is a startup and hasn’t had enough time to build credit independently of your personal credit history. A microloan can help you boost business credit, especially if you repay it diligently.
  • You fall in an underserved, minority, or unbanked group of borrowers who find it hard to access traditional bank loans.
  • You are a sole proprietor, freelancer or low-income entrepreneur who is deemed too risky by banks and credit unions.

Oftentimes microloan providers don’t put restrictions on how you can spend the money. This leaves your options pretty open. You can use the loan to meet short-term financial needs, pay bills during the low business season, or even buy equipment. It all depends on your type of business and what it needs at the time. Below is a more specific example where the type of business is a laundromat.

Microloan example

Laundromat microloan

Whether your laundromat is a full-service, fully-staffed store or a self-service, unattended type, there are certain equipment and supplies that it must have. With a microloan, you can pay for such things without having to dip into business profits.

This leaves you with some money to run the day-to-day operations of a laundromat business as you use the microloan to meet the laundromat’s capital needs. Some common use cases for a laundromat microloan include:

  • Washers and dryers
  • Water and electric bills
  • Laundromat insurance
  • Furniture
  • Laundry carts
  • Office supplies
  • Washing detergent
  • Fabric softener
  • Garbage bins
  • WIFI installation and subscription

In the case of an SBA microloan, you cannot use the proceeds for real estate or to pay off an existing debt. Those are largely the only two “don’ts'' to keep in mind.

How to qualify for a microloan

Getting a microloan can be simple and straightforward, depending on your type of business and the microlender you choose. Generally, the application process starts with a business plan and ends with you getting the necessary funding. Here’s a lowdown on how to apply for a small business microloan:

1. Create a business plan

Although not all microlenders require a business plan, some do. It provides a roadmap for your business; essentially outlining (among other things) why you need the money, how you are going to use it, your repayment plan and growth projections of your business.

Apart from making the lender feel comfortable when extending the loan, a business plan also helps you create a vision for your company. Therefore, even if the microlender doesn’t require it, it’s wise to create one anyway.

2. Determine if you’re eligible for a microloan

Eligibility for a microloan depends on the lender as well as the type of loan program you’re applying for. However, many lenders generally have the following requirements:

  • Meet special demographic requirements, if any. This is applicable to microloan programs that are focused on special groups of borrowers, such as women, veterans, low-income and minority groups.
  • Be a co-owner or sole proprietor of a for-profit business
  • Prove that you have enough revenue to pay back the loan
  • Have a credit score of at least 600. This is not a hard and fast rule; some microlenders don’t consider credit score at all.
  • Proof of diligence in paying past debts. Even if a microlender doesn’t pull your credit report, they may still ask for evidence that you have a good payment history with creditors.
  • No bankruptcies, foreclosures or outstanding tax liens.
  • Have a clear business plan that shows your growth trajectory.

3. Choose a microlender

Once you find that you meet most of the general eligibility requirements, you can proceed to narrow down your search to one or two microlenders. Ideally, the lender you settle on should have the loan product that best suits your business, and one that you can qualify for.

For example, if you’re going for a larger loan amount, then it makes sense to consider Accion who offer up to $100,000. Other microlenders cap the maximum loan amount to $50,000. Similarly, Grameen America is a safe bet if you’re a woman with a checkered credit history.

4. Apply for the loan

The loan application process may vary from lender to lender. Generally speaking, most microlenders will allow you to do everything online. Simply gather the necessary documentation and fill out the lender’s online forms.

Some of the documents that you may need to provide during the microloan application process include:

  • Government-issued ID
  • Personal and business financial statements
  • Proof of income
  • A clear business plan, outlining how you plan to use the loan
  • Proof of collateral, in case the microlender needs it

Most lenders will let you know in case they need additional documentation.

Frequently asked questions about microloans

How does a micro loan work?

In short, a microloan provides you with a lump sum of money that you have to pay back, typically with interest, via regular payments and over a set period of time.

How much is a microloan?

Microloan lenders typically cap the amount you can borrow to $50,000. However, some lenders like Accion have larger loan options that go all the way to $100,000. That said, the average microloan is about $13,000.

What can I use a microloan for?

Some of the popular uses for a microloan include purchasing equipment, acquiring inventory, expanding location, filling cash flow gaps, hiring staff, and paying utility bills. A good number of microloan lenders will not restrict how you can use the proceeds of the loan.

Where can I get a microloan?

The three main microloan providers are the U.S. Small Business Administration (SBA), nonprofit organizations, and peer-to-peer platforms. Your choice of lender boils down to your eligibility, the amount you need and terms offered by the lender.

How long does it take to get a microloan?

SBA microloans take anywhere from 30 days to 90 days. Nonprofit and peer-to-peer platforms take a significantly shorter period to process and disburse microloans. You can have the money in your business account within one or few days.

References

1. Zippia

Link: https://www.zippia.com/advice/small-business-lending-statistics/

2. Experian

Link: https://www.experian.com/blogs/ask-experian/do-microloans-hurt-your-credit-score/

3. Abrigo

Link: https://www.abrigo.com/blog/how-long-does-it-take-to-close-a-commercial-loan/

4. SBA

Link: https://www.sba.gov/loans-grants/see-what-sba-offers/sba-loan-programs/microloan-program%20

5. sba7a.loans

Link: https://www.sba7a.loans/sba-7a-loans-small-business-blog/sba-credit-requirements

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