For more than two decades, America's bank deserts have been afflicted by convenient access to payday loans. As alluring as giant bottles of soda pop, this consumer-friendly form of credit may look refreshing, its critics contend, but it leaves a bitter aftertaste of misery and exploitation. And sometimes these critics have a point.
Take the alleged actions of two Kansas City firms. According to separate complaints filed by the Consumer Financial Protection Bureau and the Federal Trade Commission in September, both companies were pursuing a similar scheme-depositing money into the bank accounts of thousands of people who had provided personal information to payday loan comparison websites but hadn't actually solicited loans from the firms in question.
After making the initial deposits, the companies extracted hefty interest fees on a regular basis. In short order, some victims found they had paid hundreds of dollars to service loans they didn't even know about. Talk about predatory.
Yet despite such egregious tactics—and despite persistent calls for stricter regulation of the industry—consumer demand for short-term, high-interest, uncollateralized credit remains strong. Every year, approximately 12 million people take out payday loans, and many find significant value in the ability to do so. In a 2013 poll conducted by the Pew Charitable Trusts, 48 percent of respondents said that payday loans "mostly help" borrowers like themselves, 56 percent said the loans had "relieved stress and anxiety" in their lives, and 62 percent said they would use the service again if they found themselves in a financial bind. Imagine how much Congress would pay for approval ratings that high!
Of course, outperforming Capitol Hill is hardly a reason to brag. (In June 2014, Gallup found that just 15 percent of Americans think Congress3 is doing a good job.) And although the Pew poll respondents had good things to say about payday loans, they expressed some dissatisfaction with the industry, too. But while legislators and bureaucrats have interpreted that ambivalence as a mandate for more regulatory intervention, it could also be viewed as a cry for more entrepreneurial innovation. Millions of people use and value payday loans -they just want better ones.
Entrepreneurial reform is happening across all sectors of the financial services industry as tech-driven startups work to meet consumer demand for lower fees, better rates of return, clearer policies, and more holistic and personalized underwriting processes. As Austen Head, the founding data scientist at Earnest-an online lending institution targeting millennials-put it in a recent blog post, the traditional credit industry "functions as an investment tool for organizations that lend," rather than a system designed to help individuals achieve financial mobility. As a result, banks charge high interest rates to borrowers, offer low rates of return to depositors, and leave huge numbers of people poorly served.
Now, however, a wave of consumer-oriented lending institutions is starting to hit critical mass. Peer-to-peer platforms like Prosper.com and LendingClub.com offer lower interest rates to borrowers than credit cards and higher yields to investors than savings accounts. In September, Earnest introduced what it calls "merit-based interest rates." Instead of simply reviewing a loan applicant's credit score, it looks at her education history, employment background, LinkedIn profile, current income, and various other metrics-then offers loans at rates as low as 4.25 percent. Affirm, a startup from PayPal co-founder Max Levchin that finances online purchases, takes a similar approach, looking at a person's Facebook profile, his cellphone account, and other non-traditional information sources to help determine creditworthiness.
Opportunities to better serve payday loan users exist as well. One company hoping to capitalize on those opportunities is a startup called LendUp. In a best-case scenario, a person can apply for a LendUp account, obtain approval, and have money deposited into his bank account within 15 minutes. And with its elaborate dashboard, snazzy loan calculation sliders, and multiple user status levels, the whole LendUp experience feels deliberately gamified-probably owing to co-founder Jacob Rosenberg's history as a high-level executive at Zynga, the company that brought a thousand digital "FarmVille" chickens to your Facebook feed.
From a regulator's perspective, such attributes might serve as red flags: They're making credit too easy! Too fun! Addictive! But while LendUp amplifies the convenience and immediacy that made storefront payday lenders popular in the first place, it also makes transparency and consumer education core components of its service. "We want to make credit accessible and convenient," says LendUp Public Affairs Director Leslie Payne. "But we also want people to understand that this is an expensive form of credit."
Thus, when you use LendUp's loan calculator, it makes very clear how much interest you'll have to pay under different scenarios and what the ultimate annual percentage rate (APR) of that interest will be. In California, for example, a 15-day $250 loan will cost you $38.60 in interest and result in a total repayment of $288.60, with an APR of 375 percent. (Rates vary by state.)
These are fairly standard rates for the payday loan industry. What most differentiates LendUp is how it treats its customers over time. Payday lending is often characterized as a form of entrapment because many lenders allow or even encourage borrowers to "roll over" loans. Instead of paying the full amount of the loan-that is, the principal plus any fees and interest that have accrued-borrowers are given the option to only pay interest. In this way, a borrower can shell out $45 in interest payments for months on end without ever reducing the principal of the original loan.
LendUp, however, doesn't allow rollovers. "When folks can't pay us back, we work with them," Payne says. "We set up a plan where every dollar they send us goes against the original balance and the original fee at no cost to them." Failure to pay back a LendUp loan can still have negative consequences—the company's FAQ says that it may eventually refer deadbeats to collection agencies or take legal action against them. But LendUp borrowers will never spend hundreds of dollars in interest fees to service a $250 loan.
In addition to eliminating one of the most widely criticized aspects of payday lending—that ability to lock borrowers into an endless cycle of rollover payments—LendUp also addresses a payday loan shortcoming that even the industry's harshest critics tend to overlook: its failure to reward customers who pay off their loans on time. "If you pay back your credit card bill on time, you get rewarded with lower rates, a larger limit, and better credit scores," says Payne. "But with [traditional] payday loans, nothing ever changes. You still only have access to the same products, at the same rates."
As its name suggests, LendUp aims to offer customers a path out of the payday loan world. It has created a tiered platform it calls the "lending ladder." New customers are granted Silver status, which allows them to borrow a maximum of $250 at rates of around $17 per $100 in California. To move up the ladder to Gold, Platinum, or Prime status, you must acquire points, which you can do by paying back loans on time or watching educational videos and taking quizzes.
Ultimately, this approach facilitates what might be dubbed a benevolent form of lock-in. While customers aren't trapped into doing business with LendUp through loan rollovers, the ladder approach does encourage repeat business: Obtaining Prime status, for example, would likely require taking out, and paying off, anywhere from eight to 10 loans.
But there's also an extremely tangible reward at the end of this process. When you attain Prime status, you can borrow up to $1,000 at APRs between 19 percent and 29 percent. More importantly, LendUp will start reporting your payment behavior to the credit bureaus so that you can potentially qualify for even better credit options from other vendors. "Our thesis is that if you let people onto the platform, they can de-risk themselves by paying back loans on time and taking credit education courses," says Payne.
To ardent regulators, this may seem overly optimistic, a reckless means of permitting high-risk borrowers to potentially subvert their own financial destinies. But perhaps it's time to give such consumers a little more credit than that.