By Marijke Peters and Andy Clark

• What are microcredit and microfinance?
• How does it work?
• Where did the idea of microfinance originate?
• What kind of interest is charged on microloans?
• Who is microfinance for?
• Why do people need microloans?
• How many people benefit?
• Where does the money come from?
• Are there any drawbacks?
• What has the United Nations done to support microcredit?

What are microcredit and microfinance?
Microcredits (microloans) are small loans offered to poor people to finance small income-generating activities. These people generally have no access to normal banking services.

Microfinance is the provision of financial support (not only microloans, but also micro insurance, savings and guarantees) - to these people.

Initially, microloans were intended to help the recipients generate income through small-scale economic activity, but now funds are sometimes also used to cover the costs of daily life, or unusual expenditure on big occasions like weddings.

How does it work?
People take out a microloan of, say, 100 US dollars; they then have to make regular (weekly or monthly) repayments, including interest, over a short period of time. When they have paid that off they are entitled to borrow a new, often larger amount with which to build up their businesses and get on the first rung of the ladder out of poverty.

Where did the idea of microfinance originate?
Microfinance has existed for centuries all over the world. It has become well known in the past few decades and the man generally regarded as the 'godfather of microfinance' is Bangladeshi banker and scholar Muhammad Yunus.

In the 1970s he founded the Grameen Bank - now one of the world's larger microfinance institutions (MFIs).

What kind of interest is charged on microloans?
The interest charged on microloans is typically high. The main reason being the high transaction costs faced by MFIs. While many MFIs charge interest rates of around 30 percent, there is also plenty of evidence that even higher rates are a regular occurrence. A study carried out by the Asian Development Bank in 2006 found MFIs in Asia were then charging up to 70 percent interest. Grameen Bank in Bangladesh charges around 20 percent.

Who is microfinance for?
Microfinance was designed to help those regarded as poor. That is a very diverse group, spread across the globe, and not located in developing countries alone. Some recipients live in industrialised nations such as the United States. Research shows that the majority of clients are women, while only 33 percent are men.

Why do people need microloans?
Microcredit is seen as a way to provide poor people with the means to participate in the economy and generate their own income. They may even become micro-entrepreneurs and set up small businesses. However, microloans are used for many other purposes as well. Dutch researcher Liselore Havermans carried out a study in the Indian city of Madurai and found most microloan recipients there use the money for everyday household expenses, even for more lavish - hence expensive - occasions like weddings.

Her findings are backed up by microfinance expert Stuart Rutherford who interviewed Grameen Bank clients and found that half the money obtained in the form of microloans is actually spent on general consumption.

How many people benefit?
The 1997 Microcredit Summit organised by Results Education set a target of reaching 100 million of the world's poorest families by 2005. The most up-to-date figures from the Microfinance Information Exchange show there were 99.4 million micro-borrowers in 2008.

Where does the money come from?
The Microfinance Institutions (MFIs) that provide microloans to the poor are mostly non-governmental organisations often set up with (external) donor funding. Some have evolved into larger specialised institutions and even borrow money from larger financial institutions, like international banks or even take deposits in their local markets.

MFIs sometimes operate like banks, but charge higher-than-normal interest rates in order to cover their costs (see below). Some MFIs are not-for-profit, others aim to make returns on their loans by charging higher interest rates than are needed to cover their operating costs.

Are there any drawbacks?
Microfinance institutions have experienced a backlash in recent years, not only because of the economic crisis. There are people who feel MFIs have transformed over the years into larger financial institutions and have lost sight of their social mission.

High interest rates, in particular, have also come under fire. Another criticism is that MFIs use heavy-handed techniques (or violence) to recover the money, sometimes sending 'thugs' to threaten people who do not repay on time.

What has the United Nations done to support microcredit?
The UN declared 2005 the International Year of Microcredit with the intention of highlighting this type of finance as an instrument for social and economic development and to achieve the Millennium Development Goals (MDGs).

Five objectives were associated with the International Year of Microcredit:
 

1. Assess and promote the contribution of microfinance and microcredit to the MDGs
2. Increase public awareness and understanding of microfinance and microcredit as vital parts of the development equation 
3. Promote inclusive financial sectors 
4. Support sustainable access to financial services
5. Encourage innovation and new partnerships by promoting and supporting strategic partnerships to build and expand the outreach and success of microcredit and microfinance.

    

Have your say
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More information
CGAP: Consultative Group to Assist the Poor - policy/research centre based at the World Bank to look at microfinance.

Microfinance Gateway - online resource centre set up by CGAP

Photo: Kipkemei Arap Lagat, a 69-year-old father of seven, standing with bricks he produced on his land near Eldoret, Kenya on August 13, 2009. Kipkemei used his first microloan from Kiva partner KADET to buy wood and straw to fire the bricks, and to pay workers to help him form and fire the bricks. Kipkemei is a member of the Banda'Ptai Tpok microfinance borrowers' group, which means "The Way Forward" in the Kalenjin language.