Microcredit 101: How do poor people borrow?

If you're interested in microfinance, but don't necessarily want to learn about graphs, differential equations and statistical techniques then you have come to the right place. We will regularly be posting 101 blogs that explain the core principles of microfinance. Check out our first post on Microfinance 101.

This week's blog is a basic introduction to microcredit.

If you’ve ever wondered what the difference is between microfinance and microcredit then rest assured – you’re not alone. The terms are commonly (and mistakenly) substituted for one another in everyday use, but they actually mean different things.

Microfinance refers to all kinds of financial services that can help poor people better manage their lives and their money, and includes microinsurance, microsavings and, yes, microcredit, which involves giving small loans to poor individuals for a range of purposes. So you can think of microcredit as a narrower subset of microfinance.

The numbers
By some estimates, at the end of 2007, as many as 155 million people had been given loans by more than 3,500 microfinance institutions (MFIs). According to FAI’s calculations, this amounts to an average annual growth rate of 28 percent since 1997, when the first numbers were released. However, MFIs are not the only providers of microcredit. Moneylenders, savings clubs, and even families are common sources of credit for the poor, and microcredit comes in an array of sizes, costs (as measured by interest rate on a loan) and tenures (time it takes for a borrower to fully repay a loan).

How microcredit is used
Microcredit refers mostly to providing microloans to poor and very poor households (those that live on US$2 per day or less) for basic needs, or to individuals that might need capital to build small businesses (microenterprises). Their access to formal capital (from places like banks or even development finance institutions) may be restricted because they lack collateral, and/or a credit history, are unemployed, or have low and uncertain sources of income, and are seen as a poor credit risk by more conventional lenders of capital.

Microcredit has come to be seen as an important tool in the fight against poverty because when it works like it’s supposed to, it helps poor households make purchases they might otherwise have been unable to finance, like starting or expanding a business. This can allow the poor to be more productive and can sometimes set households on the path out of poverty.

Studies have also shown that many borrowers don’t use microloans solely for business purposes. In the book Portfolios of the Poor, the authors profiled poor households in South Africa, Bangladesh and India over the course of a year. They found that microcredit was sometimes being used to deal with “the triple whammy of poverty” – irregular, unpredictable and small incomes, and a lack of access to financial products to manage what money they do have. Households valued credit products that allowed them to finance important life events and emergencies, serve as a means of enforcing savings discipline or to smooth consumption and meet daily expenditure needs at times when earnings were lean. At FAI, we think that by helping poor people manage their money and better cope with poverty, this use of microcredit is just as valuable as the original credit-for-enterprise approach.

Does it work?
At the FAI we are committed to exploring how (and if!) microcredit improves peoples’ lives. We do this through rigorous statistical methods called Randomized Control Trials (RCTs) that help determine the impact of financial services on the lives of the poor. Microcredit has shown promise and clear benefits for some recipients, but the jury is still out on the long-term effects.

Beyond microcredit
So what other financial services do poor households need? Stay tuned for our next blog post that will look at microsavings.