Is a microloan the right funding option for your small business?

March 28, 2017

One of the biggest obstacles facing any new entrepreneur is getting enough seed capital to start a business. There are plenty of emotional and financial hazards involved, the biggest of which is destroying previously healthy, close relationships when you are unable to pay back money you borrowed.

That’s why instead of borrowing from friends and family, entrepreneurs who require loans of $50,000 or less should consider microloans. Why $50,000? Because this amount falls into a gray area: While $50,000 is probably more money than friends and family can comfortably lend out, it’s also not enough money to qualify for a traditional loan from a bank. As a result, a microcredit provider may be your lender of choice.

The origins and purposes of microloans
The concept of the microloan is not an American one; instead, it was the brainchild of Muhammad Yunus, a Bangladeshi university professor who won the Nobel Prize for his innovation. Yunus envisioned microloans not just as starter capital for budding entrepreneurs, but also as agents of social change, empowering the less fortunate to start their own businesses, become self-sufficient, and stimulate the local economy in the process.

The idea soon spread to America, where microloans have also made an impact, especially for lower-income entrepreneurs. In contrast to international microloans in countries like Bangladesh (which can run as low as $18), microloans in the States average from $2,000 to $35,000, though few exceed $50,000.

Additionally, after the Great Recession of 2008 caused many banks to stop offering microloans, nonprofit lenders stepped in to fill the vacancy, offering a quick cash stimulus to small business owners—with impressive results. According to nonprofit lender Accion Chicago, 92% of borrowers were in business two years after receiving a loan, a marked contrast to the national average of 69%.

How can I determine if microloans are right for me?
There’s nothing inherently wrong with traditional term loans from banks, which have specific repayment schedules and interest rates (either fixed or floating). But the approval rates for banks stand at a paltry 23.1% as of July 2016. You’d probably have better luck with microlenders, especially if your capital needs are modest.

Aside from post-recession regulatory concerns, there’s also the fact that it’s more profitable and less risky for banks to lend to bigger, more established businesses. Not only do big enterprises have a healthy cash flow and a viable business model, it costs the same for a bank to underwrite $1 million and $150,000. After calculating interest and repayment terms, it’s clear that the bigger loan is a better investment for the bank.

So how do you figure out if a microloan is the right fit for you and your business? If you need a small amount of capital (under $50,000), are a new entrepreneur, or don’t have sufficient credit or business experience to qualify for a term loan from a big bank, you should consider applying for a microloan. They can also be quite affordable. For instance, lenders affiliated with the Small Business Administration (SBA) microloan program offer interest rates of approximately 8–13%, with a maximum repayment term of six years.

Also, groups like Accion may use a holistic approach to the application and lending process. That means they will take factors like a strong business plan and growth potential into account, alongside more traditional factors like credit scores. Some may even offer guidance in vital business areas such as marketing, advertising and bookkeeping.

Am I eligible for microloans?
Before you apply for a microloan, you need to consider several factors: personal financial history, how you intend to use your microloan, and whether you have any assets to serve as collateral for the loan.

Personal financial history
Though your credit score is not the sole factor in determining your eligibility for a microloan, any recent bankruptcies or delinquent payments can hurt your application. That’s why many microlenders do their best to assess personal character in a number of ways, from in-person, first impressions to a professional, thorough loan application that will likely include business plans, tax statements, projected profit and loss statements, and bank accounts.

Intended use
Generally, the proceeds of most microloans are intended for the purchase of tangible items. For instance, SBA guidelines have some clear restrictions: SBA-backed microloans can only be used for working capital, inventory and supplies, furniture and fixtures, and machinery. Note that you cannot use this capital to buy real estate or pay off debts.

You may have to put down existing business assets as collateral for your microloan. For instance, if you run a bakery, you may pledge your heavy equipment, such as ovens and industrial mixers, as collateral to secure the microloan. Though banks don’t actually want to seize your possessions in case of nonpayment (used assets are really hard to sell off), having designated collateral does reduce the risk of borrowers defaulting.

Where can I apply for microloans?
The SBA runs a very successful microloan program.

In addition to SBA-approved lenders, there are nonprofit and commercial lenders to choose from. Two popular choices are Accion and Grameen America, the American branch of Muhammad Yunus’ organization.

Other lenders include TrustLeaf, a cross between Kickstarter and a microloan platform. TrustLeaf relies on crowd-sourced funds from an entrepreneur’s social network. In exchange for capital, the borrower will set repayment requirements like loan terms and interest rates, and be very transparent about their business model, revenue, and the like.

By leveraging the power of acquaintances, friends, and family, and displaying terms in a very public manner, TrustLeaf offers the benefit of accountability and the advantages of crowdfunding.

Good things come in small packages
Ultimately, microloans are a valuable tool, not just for international development, but also for fledgling entrepreneurs (and veteran business owners). For the right entrepreneur, microloans can offer valuable capital with favorable interest rates and repayment terms, without the inaccessibility of a big bank.

Want more tips and advice from Fundera? Read "Five ways to market your business on a shoestring budget" today.


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