Second in a series.

There's one often-overlooked reason why payday loans cost as much as they do: lots of borrowers simply don't repay what they owe.

At payday storefronts in California, about 7.5% of the cash borrowed results in a bounced check, according to the most recent available data. That's in spite of safeguards — such as requiring proof of a regular paycheck and gaining access to the customer's bank account — designed to minimize defaults.

Now a new breed of startup lenders is looking to put the payday shops out of business by offering their customers an alternative that will make repayment more likely. The hope is that lower default rates will allow for less expensive loans.

The upstarts' strategy: tie the loan to the borrower's employer. By so doing, their goal is both to move the lender to the front of the repayment line and also to motivate the employee, since the same boss who is enabling the loan is also putting food on the borrower's table.

"We call it the employer affinity effect," says Jonathan Harrison, the chief program officer of Emerge Financial Wellness, referring to the impact that employer involvement can have on repayment rates. His company, one of the start-ups competing in this nascent market, claims a charge-off rate of less than 1%.

Emerge and other similar companies are upbeat about developing a thriving market for what are known in other countries as payroll loans. But an examination of the competitive landscape reveals the stiff operational challenges these companies face. It also sheds light on why traditional payday lending remains so hard to replace.

Internationally, the poster child for lower-cost payroll lending is Brazil. Brazilian law requires that the principal and interest on such loans amount to no more than 30% of the borrower's income. The law allows the lender to make direct deductions from the employee's paycheck, which reduces the risk of default.

The industry has reached a large scale in Brazil, and economists have deemed the country's experiment a success.

"The industry-level result is a net increase in loans and a drop in interest rates," concludes a study of the law's impact by Brazilian researchers. "It is difficult to over-emphasize the importance of our results."

In the United States, backers of the payroll loan model argue that a similar outcome is possible here. Some of the companies that provide them offer consumers obvious advantages over payday loans: the loans are cheaper, they are structured as installment loans that give borrowers a better chance to repay, and they offer customers a chance to build their credit scores.

San Francisco-based Emerge, founded in 2009, offers installment loans of up to eight months. Loan amounts average about $1,000. Interest rates, including fees, are 36% or less.

To employers, Emerge markets itself not primarily as a lender, but rather as a benefits provider. At participating companies, workers can get access to a personal financial coach and receive a free monthly credit score, among other perks.

But in order to succeed, Emerge needs to convince a critical mass of employers that they will see some tangible benefit from a program that provides their employees a cheaper source of credit than a payday lender does. In roughly four years, the company has made less than 1,000 loans.

Harrison acknowledges that more research is needed in this area, but on Emerge's website, the company argues that its loans improve the bottom line of its partner companies. Emerge states that its loans lead to higher worker productivity and lower sick use time, among other pluses.

"Workers living paycheck to paycheck have high turnover rates and are more prone to workplace accidents," the company states.

But that message may be a hard sell with corporate executives concerned that lending to their own employees entails unnecessary risks to their company's reputation. Another hurdle: workers are sometimes embarrassed about revealing their financial troubles to their employers.

Certain payroll lenders have taken steps to protect the anonymity of borrowers. Still, some consumers may feel more comfortable turning to a comparatively faceless payday lender.

FairLoan Financial, another San Francisco-based startup that specializes in payroll loans, is partnering with payroll providers rather than employers. That business model eliminates the need to sign up employers, but it presents another challenge: finding ways to market to employees a product that is not part of their company's benefits package.

FairLoan's borrowers can take as long as 36 months to repay loans of $500 to $5,000. Payday lenders typically make smaller, shorter-term loans, which, critics allege, are designed to trap customers in a revolving cycle of debt.

Partnering with payroll providers gives FairLoan a key advantage over the storefront lenders. Chief Executive Officer Alexander Karlan notes that while payday lenders require borrowers to provide pay stubs. "You can fake pay stubs," he says.

Payday lenders also have to contend with uncertainty about when the borrower's paycheck will be deposited. An employee may generally get paid on Friday, but what happens when a holiday falls on Friday?

"There's no national standard," Karlan says. "Every employer's different."

Legally there are restrictions on the ability of payroll lenders to require repayment directly from the borrower's paycheck — which virtually ensures the payment will be made as long as the worker keeps his job — but they can offer that option.

FairLoan provides an incentive to repay via automatic paycheck deductions by offering customers who select that choice a $15 discount on their next loan. The downside of this option is that consumers sacrifice the ability to choose which bills to prioritize. But for the lender, there are clear advantages.

Another competitor in this market, New Jersey-based FlexWage, works with employers to provide employees access to wages they've already earned, but haven't yet been paid. Employees pay a flat fee of $3 to $5 per transaction.

"There's no loans. It's simply the employee accessing the wages they've already accrued," says Frank Dombroski, president and chief executive officer of FlexWage.

Since FlexWage launched in 2009, the company has signed up about 140 employers and about 4,000 employees, according to Dombroski. "We've grown significantly over the last year," he adds. "And we're really starting to accelerate."

One limitation for FlexWage is that when people need emergency cash it is often for more the amount the employee has already accrued. The average FlexWage distribution to an employee is only around $260, according to Dombroski.

Still, perhaps the biggest challenge for the upstarts is making inroads in an industry that is so dominated by payday lenders. Just because one company offers a better deal doesn't mean consumers will choose it, especially if a pricier option is more familiar or more convenient.

Arjan Schutte, a Los Angeles-based venture capitalist who sees potential in the employer model, nonetheless expresses doubt about the ability of payroll lenders to change the behavior of financially stressed employees. "Even if the products are dramatically better in price and structure," he adds.

Some of the companies doing payroll lending today don't seem to have much interest in lowering the cost for consumers.

Shutter Finance, a Utah-based lender, partners with employers to make short-term loans to their workers. The company charges $18 on a two-week loan of $100, which is higher than the $15 typically charged by payday lenders.

That's despite the fact that default rates on Shutter loans are less than 1% in cases where the repayment gets deducted from the employee's paycheck, according to chief executive officer Jeffrey Benson.

Asked why Shutter doesn't lower the cost of those loans, given their low default rates, Benson responds that offering a cheaper loan doesn't result in more demand.

What these borrowers care about, he says, is "How much money can I get?"

This is the second story of a four-part series on efforts to lower the cost of credit for consumers with spotty repayment records. Part one is here. Up next: A look at how some companies are using Big Data in an effort to better assess the risk associated with particular borrowers.

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