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Can the Payday Loan Be Reinvented?

There's been some speculation that payday lending is set to have a big year. And with good reason. 

As mentioned in American Banker's "8 Nonbanks to Watch in 2013," several tech startups have made short-term credit the sole focus of their business model. The slideshow mentions ThinkFinance, an online business that uses data collected via social media to drive down the cost of a short-term loan, and Wonga, a short-term lender based in the U.K. that is considering a trip to this side of the pond.

Other companies are targeting the space. ZestFinance, a Hollywood, Calif., company, is marketing an underwriting model to lenders that it claims has a default rate 50% better than industry average. BillFloat, a San Francisco startup that offers a short-term lending platform, just announced it had raised $21 million to expand its loan offerings.  Also based in San Francisco, LendUp advertises transparent loans to select borrowers.   

While these companies' business models vary, their ultimate goal appears to be the same: use some form of big data to drive down the cost of a loan so underserved customers can get credit without paying an exorbitant price. (According to the Consumer Federation of America, payday loans typically cost 400% on an annual percentage rate basis or more, with finance charges ranging from $15 to $30 on a $100 loan.) Price transparency is usually part of the pitch as well.  

There's certainly a demand for this type of product. According to a report from the Center for Financial Services Innovation, an estimated 15 million Americans turned to small-dollar credit products in 2011, with fees paid to access these loans amounting to $17 billion. Other analysts have pegged the industry's annual profits much higher, at about $30 billion a year, and results of a recent FDIC survey led the agency to urge banks to expand services to the underbanked in December.

But there are reasons why most traditional financial institutions may be hesitant to partner, or alternately compete, with these startups. Just this month, five Senate Democrats urged regulators to stop the few banks that are already offering high-interest, short-term loans of their own, typically referred to as deposit advance products.

These Senators were the latest group to voice opposition to the practice. Consumer advocacy organizations, such as the Center for Responsible Lending, have long campaigned for Wells Fargo, US Bank, Regions Financial, Fifth Third and Guaranty Bank to remove these products from their arsenal.

"Ultimately, payday loans erode the assets of bank customers and, rather than promote savings, make checking accounts unsafe for many customers," advocacy groups wrote in a petition to regulators early last year.

And startups have tried – and failed – to improve on the payday lending industry in the past. TandemMoney, a South Dakota-based company hoping to wean the underserved off high-cost credit, went out of business at the end of 2012, citing regulatory scrutiny as the reason for its demise. The main complaint among its opponents: the concept – a prepaid debit card that let customers borrow short-term money so long as they set aside $20 in savings every month – all too closely resembled a payday loan.

Stigma isn't the only reason short-term credit remains a risky business. Financial institutions – small banks, especially – have long had a hard time profiting off of small-dollar loans. Tech companies, particularly those looking to underwrite for banks and not make loans themselves, may be able to drive APRs down to a level considered acceptable by consumer advocacy groups and other payday opponents, but there's no guarantee that number will be equally attractive to their potential clients (i.e., financial institutions).    

Additionally, as a Wired article points out, better data and more sophisticated risk management tools could just as easily work against underserved borrowers. 

"A lender might decide to play the spread," the article notes. "Charge the least risky customers a lot less and the most risky customers a lot more, all in the name of getting as many customers as possible," rather than just lending to the ones revealed to be good risks.

Can the payday loan ever be reinvented? If so, what terms and conditions would have to be associated with it? Let us know in the comments below.

Jeanine Skowronski is the deputy editor of BankThink. You can contact her at or follow her at Twitter @JeanineSko.





(14) Comments



Comments (14)
Most of these companies either partner with banks (in the case of Billfloat) or tribal nations (in the case of Thinkfinance and ZestCash) to avoid the existing laws regulating short-term credit. I do not think they they would go to so much trouble if they could be profitable following the law.

If they are purposely avoiding regulation, I find it hard to believe that their products are more transparent and somehow safer for consumers. Using social media or "big data" are simply ways to attract customers and enhance profitability.
Posted by PTO | Thursday, January 31 2013 at 8:05AM ET
To PTO: You state that the companies partner with banks to avoid existing laws re: short-term credit? How does that work? Do banks not have to comply with laws?

Companies partner with banks and others to respond to state laws which make it impossible to lend small amounts of money for a short period of time. This has nothing to do with transparency or safety - federal laws and bank regulations still apply - this has to do with state licensing requirements, state usury caps, and idiosyncratic state restrictions on loan amounts and terms.
Posted by XYZ1 | Thursday, January 31 2013 at 10:45AM ET
There is a very big need for small, short-term lending. The reason for the exorbitant rates really has nothing to do with an inability to "be profitable following the law." Rather, by staying under the radar, current payday loan firms reap obscene profits because they can. They have no competition and are preying on people in a desperate situation. They have no brick and mortar facilities and virtually no overhead. After just two or three minimum payments from their victims, the payday loan firm has recovered the initial loan and everything after that is just gravy. Real financial services companies could easily undercut the exorbitant rates of the payday loan firm thereby making it more likely that the loan will be repaid. Finally, payday loan users tend to access the system again. Making it possible to repay the loan without gutting the user gives them incentive to stay within the regulated system. Emergence of the payday loan scam is more indicative of eroding wage scales and buying power and is only a symptom of growing cancer.
Posted by RSE Journal | Thursday, January 31 2013 at 10:48AM ET
Before one goes to market with a product, there must be demand for the service or it doesn't work. In recent meetings with regulators, there seems to be recognition that people living pay check to pay checks do not have money each month to put aside money for emergencies., therefore short term loans are in demand. The current problems exist from tying repayment to the next paycheck, which in most cases is unrealistic. Consumer advocates should encourage banks to move vigorously into this market. They have a much lower cost of funds and therefore a price advantage. The is plenty of room between what the payday and title lenders charge and what the banks need to charge to compensate for he risk and still make a profit. Wouldn't these products be more consumer friendly if regulated by bank regulators,, but there has to be enough profit to cover the losses and the expensive learning curve. Besides, banks already have a short term loan product, they just call it free checking.
Posted by T Stephen Johnson | Thursday, January 31 2013 at 12:03PM ET
Payday lending can definitely be reinvented. But I am not sure if these companies are the right ones to do it. I disagree with RSE, most of them are not making obscene profits, and at least the public companies have lower margins than banks. I agree with T S
Posted by PTO | Thursday, January 31 2013 at 5:58PM ET
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