Microloan Basics: What Small Business Owners Must Know Before Applying

Starting or growing a small business requires capital. Unfortunately, for many entrepreneurs, it can be very difficult to secure financing from traditional banks. Institutional lenders often prefer making larger small business loans because they stand to make more money on those loans. At the same time, they want to mitigate risk, so these loans may require extensive collateral, excellent credit scores, and proven business models. For many startups or businesses operating in underserved communities, it may be a better idea to fill out a micro loan application.

A microloan is a small-dollar loan. This flexible financing option is designed to provide quick capital to businesses with lower eligibility requirements. While many financial institutions overlook very small businesses, these business owners can find necessary loan funds through microloans.

What Is a Microloan?

A microloan is distinguished from other funding options by its size and lender. While the U.S. Small Business Administration (SBA) defines them through the SBA Micro loan program as any amount under $50,000, many of these loans are much smaller. The average SBA Microloan, for instance, is about $13,000.

Microloans are invaluable for small needs like:

• Purchasing essential equipment.

• Funding inventory for a large order.

• Covering initial marketing expenses or website development.

• Securing working capital during a slow season.

The micro loan application process is typically less extensive than other traditional loan programs, and loan processing may be faster due to the smaller amounts.

Who Provides Microloans?

Microloans are rarely offered by large commercial banks. Instead, they're typically provided by mission-driven lenders, such as:

1. Community Development Financial Institutions (CDFIs): These are private financial institutions certified by the U.S. Treasury. Their mission is to serve economically distressed communities.

2. Non-profit microlenders: Organizations focused on specific demographics.

3. SBA Intermediaries: Intermediary lenders and nonprofits that receive funding from the SBA Microloan program and lend it out locally.

These lenders prioritize community impact over profit margins. They offer flexible terms and extensive support alongside the capital. Understanding your lender's mission is key before starting your microloan application.

Who is the Ideal Candidate for a Microloan?

Microloans are structured for businesses that struggle to meet traditional lending requirements. If you fall into any of the following categories, it may be a good idea to fill out a micro loan application.

Startups and Early-Stage Businesses

Banks often require years in business before they will consider lending to a company. Microloan providers understand that every business has to start somewhere, and capital can make a big difference in those early stages. Microloans for startups are available, and providers will focus underwriting less on time in business and more on the feasibility of the business plan.

Underserved or Minority-Owned Businesses

According to the Consumer Financial Protection Bureau, Black business owners receive less information about lending options and less encouragement to apply. Systemic biases and a lack of established relationships can prevent minority and women entrepreneurs from accessing available credit.

Microloan providers promote economic equity, which includes supporting underserved business owners and investing in low-income or underserved communities. Rather than going over a credit report with a fine-tooth comb on a microloan application, they may focus more on your character and commitment, and the strength of the business plan.

Businesses Lacking Collateral

Traditional banks typically require collateral, such as real estate or significant equipment, to secure a loan. Many startups or service-based businesses don't own hard assets, and few entrepreneurs want to put their own house up as collateral. A micro loan application requires less emphasis on hard collateral. The lender may instead accept a lien on the financed equipment or a personal guarantee, instead.

Businesses with Low or No Credit History

An entrepreneur may have little personal credit history or past credit issues. While a credit score is still considered on a micro loan application, it's weighed less heavily than the business's current cash flow and future potential. Your creditworthiness matters when it comes to determining the interest rate and loan terms, but it won't necessarily keep you from being approved for microloan for small businesses.

What to Know About Microloans

Before submitting a microloan application, you have to understand the financial commitment and the benefits available to you.

Loan Amounts

As mentioned earlier, the maximum microloan is usually $50,000. However, the amount you qualify for depends on several factors:

• Need: What exactly are you purchasing, and do projected returns justify the cost?

• Repayment capacity: Does your business generate enough consistent cash flow to handle the monthly payment?

• Lender limits: Some microlenders have internal caps lower than the SBA limit.

Repayment Terms

Repayment terms on microloans are typically shorter than traditional bank loans but longer than high-interest, readily available financing like credit cards or merchant cash advances.

If you're using a microloan for a specific purchase, the microlender may align the term with the useful life of the asset you're buying. For instance, a loan for durable equipment might be several years, while a loan for inventory might be much shorter.

Interest Rates and Fees

Microloan interest rates are competitive with commercial bank loan rates, but they're usually a bit higher. That's because they tend to be a bit riskier for the lender. While the interest rate on a micro loan application might be slightly higher than a prime bank rate, the benefit of getting access to capital you wouldn't otherwise have usually outweighs the cost.

Like any other type of financing, microloans also have fees. Expect an origination fee and potentially micro loan application fees to be rolled into the total loan amount.

Technical Assistance

One of the most valuable, yet often overlooked, aspects of a microloan is the access it provides to technical assistance. Since most microlenders are equity-motivated institutions, they provide far more than just cash.

CDFIs, in particular, are holistic lenders that see their role as supporting entrepreneurial growth. After getting a micro loan application approved, you may have access to:

• Mentorship: Pairing the entrepreneur with an experienced mentor.

• Financial literacy: Workshops on cash flow management, budgeting, tax compliance, and more important topics.

• Market analysis: Assistance in optimizing pricing or identifying new customer segments.

• Credit building: Guidance on how to successfully repay the microloan to build a strong credit profile for future, larger financing.

Successfully navigating the micro loan application and repayment process will establish you as a reliable client and help build your business credit. That can serve as a valuable stepping stone towards larger, lower-cost financing in the future.

The Microloan Application Process: Step-by-Step

The microloan application process is focused on partnership and education. It requires a slightly different approach than a traditional bank application.

1. Research and lender selection: Find a local CDFI or nonprofit lender that serves your area or industry. Familiarize yourself with their mission, lending limits, and eligibility criteria. Contact them early before you need funding to get your micro loan application off on the right foot.

2. Prepare documentation: While less restrictive than banks, microlenders still require documentation for a micro loan application. These documents may include a business plan, financial statements, tax returns, and a use of funds statement. Requirements will vary by lender.

3. Complete the application: Fill out the micro loan application form completely and honestly. You can usually fill out an application online or in person. Be honest and transparent about any past financial challenges.

4. Interview: In most cases, the lender will schedule an interview. This is your chance to sell your vision and demonstrate your ability to repay the loan. Be prepared to discuss your projections and contingency plans. You'll likely also have to agree to participate in technical assistance.

5. Underwriting and closing: If approved, the underwriting team finalizes the loan terms. You'll review and sign the loan agreement when you're satisfied. A thorough microloan application will lead to a smoother closing process.

Final Thoughts

Many small business owners don't need a major loan to get off the ground. But many find obstacles when they try to get approved for small loan amounts from institutional lenders. The small business microloan is a crucial tool for these borrowers.

Understanding the unique requirements and mission of microloan providers is the first step toward success. By approaching the microloan application with a clear business plan and realistic financial projections, small business owners can secure the capital (and guidance) they need to launch, grow, and stabilize their businesses. By taking the time to create a thorough micro loan application today, you could set your business up for long-term success.