How Do Micro Lending Platforms Work?

Feb 16, 2022 5:34:14 PM

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The most wholesome and altruistic innovation to come out of the FinTech, or financial technology domain is that of microlending apps and platforms. Micro lending platforms leverage peer-to-peer (P2P) technologies to offer loans to small businesses as well as personal microloans to individuals without a standardized credit history.

Microloans offered to individuals on these platforms are not just funded by banks or credit unions but independent entities as well. These loans could be funded by singular entities with the necessary disposable income or a group of individuals, each contributing a portion of the loan amount.

In this article, we will first talk about why microlending is advantageous and where it is of the most value. We will then go on to explore how micro lending platforms actually work.

What Is The Benefit Of Microlending Platforms?

As per statistics aggregated by The Borgen Project, less than about a third of the world's population has a tangible financial identity. This leaves about 70% of the world lacking a trackable credit history or a means to apply for a loan. The financial system is inaccessible to several pockets of the population because of a lack of a structured credit line.

One of the reasons why poverty persists in developing countries is that people below a certain economic threshold are overlooked by the countries' monetary policymakers. And that is where personal microloans factor in and make a significant difference in the lives of the less fortunate. When accessing microloans through a micro lending app or platform, people do not need to meet a strict set of financial prerequisites to assess their credit scores.

Micro lending is different from conventional lending in how it is more inclusive and accepting of small business owners and people with no credit history or means. Today, microloans are available via mobile apps to anyone with a mid-range mobile device. The outdated notions around credit history and traditional channels of lending are being challenged by a series of mobile app-enabled micro lending platforms.

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The Micro Lending Workflow

The concept of micro lending was popularized by the Bangladeshi entrepreneur, Mohammad Yunus, who set up a microfinance outfit called Grameen Bank. It is known for loaning billions to impoverished people from all walks of life and all purposes; opening small businesses, organizing functions for life events, and for funding their education. Micro lending apps take this one step further by providing an easy route to apply for microloans and get verified for the same.

Here's how micro lending platforms work:

  • Investors interested in offering microloans get into a partnership with the online micro lending platform and look for opportunities to invest.
  • Borrowers joining the platform can either get 100% funding for their microloan from a single investor or in case of a large sum, they can get it aggregated from several investors.
  • Based on requests from borrowers and the size of loan required, investors bid to either pool together or lend individually.
  • In case the application for a loan attracts bids from investors that total less than 100% of a borrower's requirement, the application gets rejected.
  • In case the application gets processed, the borrower must repay the loan based on the conditions set by the investors.
  • The investors have the flexibility to choose the period of repayment, the interest rate, all within the compliance norms of the region where the loan agreement gets signed.

Credit Rating Method For Micro Lending Platforms

Because of the lack of traditional credit history, the credit rating of applicants of microloans is based on their digital footprint. The observations to measure the repaying capability of an individual are present on their smartphones, which micro lending asks permission to track and quantify.

Every digital payment made for phone bills, electricity bills, travel tickets, education fees, etc. generates notifications on smartphones. These notifications are used as signals about the borrower's financial history as well as current and potential financial behavior. This data is fed into algorithms that measure the creditworthiness of individuals.

So finally the following three steps help determine a credit rating for the borrower on the micro lending application:

  • A standardized borrower rating is calculated using traditional scoring models and previous clients' credit histories built over time. 
  • The probability of loan repayment is determined based on the aggregate of historical repayment trends tracked over a particular time on the app.
  • The app then combines this with traditional credit scoring models used by financial institutions.

Partnering With Banks

Organizations running such micro lending platforms can partner with banks of their choice to maintain a uniform line of credit. This can be beneficial for the organization in case there is uncertainty regarding the funding capabilities of investors who sign up. Banks can be relied on for keeping the money from investors and borrowers as a liquid asset.

A micro lending organization partnering with a bank can also make use of the latter's established compliance procedures when designing and innovating on new types of personal microloans. In a more cash-intensive move, these organizations can partner with multiple banks to expand on their product catalog.

Loan Agreements And Territorial Laws

When establishing a P2P lending architecture for an app-based lending platform, these companies draft loan agreements. This allows newly onboarded users to understand the terms of use right at the onset to avoid any confusion at a later stage. While drafting such an agreement it is important to take into account compliance with national and international laws. If a micro lending platformer based in the US wants to offer loans in, say, Venezuela, they would have to model the app and the personal microloans in accordance with local financial norms.

Multiple Integrations

There are several integrations that are viable for a micro lending platform. Third-party solutions for payment gateways, wallets, and banking compliance serve as integrations for these apps. These integrations are usually meant for keeping some scope for scalability. Sometimes, in more advanced iterations of these apps, custom-developed neural networks assess borrowers' eligibility based on accounting and social media data. Moreover, there could be integrations to include e-signatures, automatic collection of payment debits, ERP or MIS, and communication modules via text, email, and video conferencing.

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Personal Microloans Provide Inclusive Financial Help 

There are millions of people stuck in the cycle of poverty who can benefit from easily accessible micro lending platforms. As smartphones are becoming more and more available to every economic stratum of society, microloans are also reaching individuals who cannot afford to depend on traditional financial institutions for loans.

Many micro lending apps are entering the market with the motive to improve lives and provide opportunities to people with a lack of credit history due to unfortunate circumstances. If you are planning to attempt something along these lines, you can learn how Daffodil's FinTech Solutions can help you with your goal.

Topics: Fintech

Allen Victor

Written by Allen Victor

Writes content around viral technologies and strives to make them accessible for the layman. Follow his simplistic thought pieces that focus on software solutions for industry-specific pressure points.