Can a London Startup Make Payday Loans Respectable?

Being poor is expensive.

Take, for example, one service targeted at the down-and-out: payday lending. Drive past any dusty suburban strip mall and neon lights flicker the promise of a "Cash Advance Here." Payday lenders provide very small and very short-term loans (often just a couple hundred dollars for a week or so, until the next paycheck arrives). They're not for everyone, but for families living from one paycheck to the next, these loans are sometimes the only way to keep the lights on.

Payday loans have long been vilified by politicians and the media because of their exorbitant fees. A two-week loan for $300 can easily carry $50 in fees and interest. That's a compounded annual interest rate of 5,403 percent. And because the borrowers can be desperate for cash, payday lending has become nearly synonymous with words like "usury" and "predation." Fifteen states have cracked down on the practice, and Congress is considering a nationwide interest-rate cap, which would put much of the sector out of business.

A London-based company, Wonga*, thinks it can improve that image. Although it avoids the term, Wonga operates like a traditional payday lender—it provides quick cash at high prices. Yet you'll see no gaudy neon at its headquarters, because Wonga is unique in blending strip-mall finance with Silicon Valley technology. All of Wonga's loans are made online. (For now, the service is only available in the United Kingdom.) They're available 24/7, most borrowers receive their cash within an hour, and the lending process is entirely automated. A prospective borrower plugs in eight pieces of data, and Wonga uses that data (plus some sophisticated algorithms) to pull an additional 1,800 pieces of information from public databases. That enables Wonga to make a near-instantaneous decision about whether to offer someone cash—up to 200 pounds for a first-time borrower.

Technology bloggers have praised about Wonga's high-tech algorithms—Sarah Lacy of Techcrunch wrote that "it's one of the most dramatic examples I've seen of a Web company using what the Web does well to remake lending"—but what's much more interesting about Wonga is that it considers itself to be a heretofore unknown creature: a payday lender with a conscience.

That's particularly poignant in light of this week's news that American banks will rake in a record $38.5 billion in overdraft fees this year, according to a study by Moebs Services. Since last fall's financial apocalypse, commercial-banking giants like Bank of America and JP Morgan Chase have relied on such fees to bolster the bottom line. They're little different from a payday loan—they provide a quick jolt of temporary cash, but charge dearly for the privilege. Bank of America, for instance, will slap a $35 penalty on any customer that overspends his or her account by more than $5. Depending on how much you go over, the overdraft fee, if it were calculated as an annual interest rate, would be eye-bogglingly high. Errol Damelin, the CEO of Wonga (which is Cockney slang for "cash"), had his employees try to do the math for the overdraft fees charged by one UK bank. "Literally, we haven't found a machine yet that could give us enough zeroes to actually write it out," Damelin says. "It's like a trillion percent. It's insane."

That might sound like an odd criticism coming from the chief executive of a payday lender, which charges a gasp-inducing 2,689 percent compounded annual interest rate for its loans. Damelin and his team go to great lengths explaining why that particular figure is meaningless, even though EU regulations require him to display it prominently on the site. "If we did a 12-month product, we'd price it very differently," he says.

Despite such defenses, Wonga is forthright in admitting that its loans are an expensive luxury. (In concrete terms, a 100 pound loan for two weeks costs the borrower just over 20 pounds.) Where payday loans go from being an expensive but occasional necessity to something more malicious is when borrowers are lured into a debt trap. Critics--including Damelin--charge that unscrupulous lenders push the cash-strapped into borrowing more money than they need. When they can't make repayments on time, the lender racks up penalty fees and interest. According to the Center for Responsible Lending, an industry watchdog, in 2006 some 90 percent of the industry's revenues were collected from just such "trapped borrowers," extracting $4.2 billion from American families. "I always assumed that when you lend people money, you want them to pay you back," says Damelin. "But credit card companies, banks, payday guys—they make money when people don't pay them back in full."

Wonga argues that its business model does away with the debt trap. It rejects 80 percent of applicants as unqualified, and lets borrowers customize the size and duration of the loan. All the fees are transparent, and borrowers can't take out a new loan before paying off the old one—a common tactic unethical lenders use to keep people in debt.

That said, there are still those astronomical fees, which strike most people as unjust. When three prominent venture-capital firms invested in Wonga in mid-June, aiming to export its cash-lending business worldwide, Umair Haque, a blogger at Harvard Business Publishing, wrote that Wonga is "an economically, strategically, competitively, and ethically bankrupt choice to make."

The reality is probably simpler--and less extreme--than either Lacy or Haque would have it. As Damelin puts it, Wonga is merely "trying our best to be responsible in a really controversial space."

*Note: Since Wonga is UK-only for now, U.S. visitors can only view the site via a proxy server, which is why the Wonga link has a banner ad up top.