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Microfinance institutions disburse these small loans (along with other types of financial services) to the entrepreneurial poor who use them to develop and expand informal businesses, which in turn allow borrowers to typically increase profits.
While increased profit doesn't directly translate into immediate and complete freedom from poverty, it does allow the poor to more effectively cope with and combat the suffocating realities of extreme poverty.
Historically, the poor were written off by commercial banks as not 'creditworthy,' barred from access to important financial tools such as working capital loans, savings and insurance.
However, since the first microloan was dispersed in 1973 in Recife, Brazil, by an ACCION-led nonprofit, the working poor around the world have proven to be excellent credit risks and prudent users of "micro" financial services - today, microloan repayment rates for ACCION's partners worldwide average 97 percent.
How do microloans help the poor? Most of the world's poorest people often cannot find steady work, and many who do are not paid a living wage.
To feed their families, the poor often turn to self-employment in any way possible - they sell fruit in the local market, weave clothes, open small bakeries.
For this vulnerable population of hard-working microentrepreneurs, microloans can be instrumental in breaking the cycle of poverty.
A small loan can be used to buy raw goods in bulk or purchase important equipment such as a sewing machine.
A loan can also help the poor cope with health emergencies or afford larger expenses such as education, funerals or weddings.
In general, these financial tools can help the poor to expand their microenterprises, save money and work towards a better standard of living.
How do informal loans compare to microloans? It is important to note that the "...
notion that microcredit brings loans to people who previously had no access to them is widespread but mistaken" (CGAP).
The poor often do have access to informal credit channels - through moneylenders, loan sharks or family members; the challenge for microentrepreneurs in developing countries is finding access to reliable and safe credit.
Distributed by microfinance institutions, microloans are a much more reliable asset for the poor - and for a group with irregular and uncertain incomes, this financial constancy can be life-changing.
Microloans help the poor manage irregular incomes, smooth consumption and often enable them to work their way up the economic ladder with dignity and pride.
Are all microloans the same? With larger loans reaching a few thousand dollars, microloans vary in size depending on multiple factors- including regulatory environment, standard of living in the particular country, size of the microfinance institution and individual client evaluations.
The evaluation process to determine credit potential is just as important in microfinance as it is in any other 'formal' financial practice.
Like traditional banks, ACCION partner microfinance programs assess potential borrowers using measurements like business assets - which could be as small as a tin stall in the market, amount and cost of goods sold, cost of raw materials and household expenses or collateral.
However, unlike traditional banks, our partner programs do not make loans based purely upon quantitative revenue or collateral.
We also send loan officers to meet potential borrowers in their places of work, to weigh qualitative variables - including interviews with clients and references from customers and neighbors - to assess a client's character, understand their business and determine the microentrepreneur's willingness and capacity to use and repay loans.
This character-based lending allows us to go "beyond the numbers" and develop a more complete picture of a potential borrower than a traditional credit score.
If not as evidence for the success of microloans, then at least as a small testimony to the effectiveness of microloan due diligence, is the fact that borrowers often repay their first loans and return for increasingly larger loans in a stepped-lending process.
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