Everyone knows that capital is critical for starting or growing a business. You need to buy supplies, pay for equipment, lease a building or a fleet of vehicles, and perhaps hire employees or a sales staff. If you don't have the cash on hand, you apply for a loan at a bank, right? But what if your business gets turned down for a loan by conventional banks? What happens when bank credit to small businesses tightens up? What do you do? One option would be to apply for a microloan, a small business loan ranging from $500 to $35,000 (and sometimes more) that is well-suited for small businesses or startups that maybe don't have a credit history, can't secure the funds through a bank loan, don't have collateral, or have other risk factors.

Microloans are often so small that commercial banks can't be bothered lending the funds. Instead of a bank, you need to turn to a microlender. Microlenders are non-profit organizations that work differently than banks. Microlenders offer smaller loan sizes, usually require less documentation than banks, and often apply more flexible underwriting criteria. There are a few hundred microlenders throughout the United States and while they often charge slightly higher interest rates for loans than banks, they've helped 250,000-300,000 small businesses each year and lent more than $2 billion nationwide during the past 10 years, according to the Association for Enterprise Opportunity (AEO), the trade association for microlenders.

"Microloans are really for that startup entrepreneur or an entrepreneur in an existing business facing a capital gap who needs to secure capital for new equipment or to service a contract," says Connie Evans, president and CEO of AEO, which represents 400 mostly non-profit microlenders and microenterprise organizations. "You don't have to be turned down by a conventional financial institution. However, people use microloans oftentimes because they want a smaller amount and a typical financial institution is not going to consider such a small amount for a loan."

The following pages will detail how to decide if a microloan is right for your business, how to find a microlender, how to apply for a microloan and start making payments.

Deciding to Apply for a Microloan

Introduction to microloans
Microloans are ideal for small business owners who operate microenterprises -- businesses with fewer than five employees -- and are unable to access credit from conventional banks. These types of small business loans are frequently used for home-based, office-based, street-based, or storefront businesses, such as restaurants, beauty salons, and taxi operators. "Our requirements are set so that people who wouldn't be able to obtain a loan from a bank can obtain a loan from us," says Laura Kozien, communications director for ACCION USA, a microlender based in New York City. "We make access to capital closer to reach."

During economic downturns, the number and types of businesses applying for microloans can change. In 2009, more than half of member microlenders reported to AEO that they have seen an increase in the number of entrepreneurs reaching out for capital after bank credit tightened up. In addition, Evans says, the types of people applying for microloans -- typically many low income and immigrants apply -- expanded to include entrepreneurs who were highly educated and recently became unemployed. They tended to have higher credit scores but still couldn't get loans from commercial lenders.

There are several pros and cons of microloans.

The benefits of microloans

  • Microloans make capital available in small amounts so that a business doesn't borrow more money than it needs -- and so that it can get accustomed to making the debt payments before it borrows more for expansion.
  • Microloans can range from a few months to several years are most often structured as installment loans, consisting of equal monthly payments of interest and principle.
  • Microlenders often act as counselors and help nurture small businesses to help them draft business plans, devise marketing strategies, and understand their business before taking on debt.
  • Microlenders may make loans to those with less-than-perfect credit (a credit score of under 680), although most will require some credit history.  If you have no credit history, you may take out a "credit builder" loan -- a small, short-term loan that allows microlenders to help clients establish and build their credit.

The disadvantages of microloans

  • The annual interest rates charged by microlenders tend to be slightly higher than those charged by banks. Depending on the borrower's credit and other factors such as business experience, rates can range between 12 and 18 percent. But Evans points out that these rates aren't as high as another alternative frequently used by small businesses to access capital -- credit card loans.
  • The average loan amount is small -- ACCION's average loan is $6,000 -- which is often not enough to fund a business or startup.
  • Microloans tend to be capped at $35,000 under the U.S. Small Business Administration guidelines, although the White House has been eager for Congress to raise that cap to $50,000. Some microlenders will lend up to $50,000 or more but the amounts tend to limit the size and type of businesses that apply.

Qualifications for a microloan
Every microlender has its own criteria to determine eligibility, Evans says.  In general, applicants must be 21 years or older, although ACCION sets the qualification age at 18. You must also be the sole business owner or apply with co-owners as co-borrowers. You must apply for a loan for business purposes.  

You don't need perfect credit to qualify for a microloan, since microlenders often consider your credit history in the context of your whole application.  Weak credit may be offset by strengths in your application, but issues like outstanding tax liens, recent bankruptcies or recent delinquent payments usually will disqualify you.

There are ways to get around some of the weak spots in your credit past. "Your chances of getting a microloan will not rest solely on past credit history," Evans says. Some borrowers have no credit history or were saddled with bad credit as a result of a divorce or other issue. Microlenders will take into account other factors than credit when weighing your qualifications. "Our members will look at the history of the business or if it's a new business they will want to see your plans for that business," Evans says. "One of the things that is so unique about microlenders is that they will also talk to you about your plans, your vision for the business. They want to get to know the person. A major piece of the decision has to relate to character."

Applying for a Microloan

Applying for a microloan is like applying for a job.  The more professionally you handle the process, the more likely you are to be successful.  Since microlenders evaluate your character as well as your credit score, be sure to demonstrate professionalism by submitting a complete loan application, organized income and expense statements, and requested supporting documentation. The strongest applicants demonstrate their ability to repay the loan through positive cash flow and experience in their field.  They also provide strong references, well-organized records, and collateral or a co-borrower to support the loan.

Find a microlender in your area

The AEO maintains a website that lists microlenders by state. Some microlenders, such as ACCION USA, have the ability to make loans nationwide over the Internet. The U.S. Small Business Administration tries to make more capital available for microloans by working with lenders and making funds available. The SBA maintains a list of certified microlenders online.

Required documentation
Once you locate a microlender, you will to start the application process. You will need need to provide your microlender with some basic information. Here's a checklist:

  • A government ID -- such as a social security number or Individual Taxpayer Identification Number (ITIN).
  • Proof of income or something to demonstrate a cash flow in the business.
  • Financial statements. For established businesses, financial statements such as profit and loss statements or your QuickBooks statements. In some cases, tax returns or professional financial statements may be required.
  • What the loan will be used for. A carefully thought out description of what the loan will be used for -- detailed plans to increase business operations and profits are more likely to be approved.
  • A business plan. For startups, a detailed business plan and cash-flow projections will be required. Writing a business plan can also help pinpoint your professional goals and strategies for success.
  • Investment. The business owner will need to demonstrate his or her investment in the business; this can include cash expenditures and "sweat equity."
  • Collateral. Personal and business assets may be used to secure a loan; this can include equipment, automobiles or other assets.
  • References. You may need a list of personal and professional references.

After the loan officer has received your application, s/he will contact you to review the request.  The loan officer may also conduct a site visit to verify the business location and the nature of the business.  In the case of a home office, the loan officer may visit to verify that a home office exists, and how it is organized. Finally, the loan officer will assess any business or personal items pledged as collateral.

Closing the loan and starting to make payments

Closing Documents
After your loan has been approved, you will receive a set of closing documents from your loan officer. Be sure that you fully understand the closing documents, especially the promissory note, which details the amount of the loan, interest rate and maturity date.  It's also a good idea to ask for an amortization schedule, which lists all the payments that are due over the life of the loan.  Confirm the best way to reach your loan officer or other staff person should you have questions.

Many microlenders will deposit your loan directly into your bank account (and will debit loan payments from the same account). If not, you will receive a check with your loan disbursement.

Remember, microlenders regularly report repayments to the three personal credit agencies (Experian, Equifax, TransUnion).  Late payments will appear as blemishes on your credit report, so be sure to pay on time.  Most microlenders will allow you to choose your own payment date, or at least will give you several options. Checks often take several days to clear, so don't wait until the last minute to deposit funds into your account.  One of the benefits of a microloan is that they give individuals with a less-than-perfect credit the opportunity to build and improve their credit scores.  Often, prompt payments will also qualify you for lower interest rates on subsequent loans.

Be sure to maintain communication with your loan officer or another designated staff person. Microlenders have your best interest in mind, and most will work with you to resolve issues that you have making payments, especially in the case of unavoidable hardships.  However, not communicating with your contact at the microlender could lead him or her to think that you are unwilling to pay.

"One of the great benefits is the one-on-one attention you can get from a loan consultant. A bank will hand you the application and expect you to handle it on your own," says Kozien. "There is a personal feel to the lending we do."

Fresh Inc.: Microloans Filling a Gap
This financing option shouldn't be overlooked as a resource for smaller capital infusions.

The Kiva Connection
Microloans for all.

An Insider's Guide: Microloans   Very small businesses, often in-home and held by low income or minority owners, can borrow up to $35,000 for general business purposes.

A non-profit organization that offers small business loans up to $25,000.

An Insider's Guide
A non-profit organization that offers small business loans up to $25,000.

Association for Enterprise Opportunity
An association that works to advance the field of microenterprise development.

U.S. Small Business Administration
This federal government agency provides assistance to help start, build, and grow businesses. It also helps make capital available for microloans to microlenders. A list of certified microlenders is maintained on the agency's website.