Microfinance is often defined as financial services for poor and low-income clients.  In practice, the term is often used more narrowly to refer to loans and other services from providers that identify themselves as “microfinance institutions” (MFIs).  These institutions commonly tend to use new methods developed over the last 30 years to deliver very small loans to unsalaried borrowers, taking little or no collateral.  These methods include group lending and liability, pre-loan savings requirements, gradually increasing loan sizes, and an implicit guarantee of ready access to future loans if present loans are repaid fully and promptly.
 
More broadly, microfinance refers to a movement that envisions a world in which low-income households have permanent access to a range of high quality financial services to finance their income-producing activities, build assets, stabilize consumption, and protect against risks. These services are not limited to credit, but include savings, insurance, and money transfers.

Why does Microfinance work?

Microfinance is a great way to bring financial services to poor clients.  Before, these clients had a very difficult time in getting any sorts of loans.  They were targets of people called “loan-sharks”.  These loan-sharks would operate across several villages at a time charging extremely high interest to their clients.  The reason for this interest is because third-world countries have no system of credit checks or background checks.  Microfinance is able to change all of this because it focuses on one individual village at a time.  It uses the social status of an individual as an incentive for repayment of loans.  In these villages the only way one is able to demonstrate their social status is with the respect they have among their peers. Typically, a small sum of capital is given to members of a group, who are all collectively responsible for paying back the loans.  Because the only asset these people have is their reputation all of the members of a given group pay back their portion in order to maintain their status.  Also if another member of a village wants to join the group that is receiving loans, it is the group that decides if he or she deserves a loan, because they can assess the value of that person’s reputation.    Microfinance also uses a technique of gradually increasing loans.  For example, if I give you one dollar this week and you repay me on time, I will give you two dollars next time.  If I get repaid the two dollars one time, I will give you three dollars next time.  This gradual increase of money also provides a strong incentive to repay loans.

How does microfinance help the poor?

Experience shows that microfinance can help the poor to increase income, build viable businesses, and reduce their vulnerability to external shocks. It can also be a powerful instrument for self-empowerment by enabling the poor, especially women, to become economic agents of change. 
 
Poverty is multi-dimensional. By providing access to financial services, microfinance plays an important role in the fight against the many aspects of poverty. For instance, income generation from a business helps not only the business activity expand but also contributes to household income and its attendant benefits on food security, children's education, etc. Moreover, for women, who, in many contexts, are secluded from public space, transacting with formal institutions can also build confidence and empowerment. 
 
Recent research has revealed the extent to which individuals around the poverty line are vulnerable to shocks such as illness of a wage earner, weather, theft, or other such events. These shocks produce a huge claim on the limited financial resources of the family unit, and, absent effective financial services, can drive a family so much deeper into poverty that it can take years to recover.