A startup tries to fix payday lending

October 12, 2012, 12:35 AM UTC

FORTUNE — Payday loans are considered a dirty business, both figuratively and literally. Corner stores in rough neighborhoods, bulletproof glass and the quiet desperation that leads someone to borrow $200 at a 400% APR.

But a new startup called LendUp is hoping to change all that. And yesterday it announced a seed round of venture capital from backers that included Andreessen Horowitz, Google Ventures and Kleiner Perkins Caufield & Byers.

Founded by a pair of stepbrothers, the San Francisco-based company offers an online platform for those in California seeking to borrow up to $250 a 30-day basis. The rate is 15% plus fees, which means that borrowers would repay a total of $294 after 30 days (minus $0.30 per day for early payment). State law prohibits LendUp from rolling over the interest, which means that delinquents do not end up owing the company hundreds (or even thousands of dollars more). Instead, it tries to work with struggling users to make repayment arrangements, although that can ultimately include collection agencies and calls to credit bureaus.

To be sure, LendUp isn’t the first Internet startup to try its hand at payday lending. Nor is it even the first to use big data analytics to determine credit risk, or to raise venture capital from big name investors. Wonga has been doing it for several years in the UK (at even more usurious rates), while ZestCash began with a similar premise to LendUp before transitioning into a provider of big data on the under-banked to more established lenders. Moreover, many of the larger bricks-and-mortar payday lenders also have online offerings.

The difference, LendUp argues, is that it’s using payday as a gateway to providing better loans, rather than as a profitable end in itself.

“If users pay back early or on-time or take one of our credit education courses, they instantly get lower fees on their future loans,” explains LendUp co-founder and CEO Sasha Orloff. “You don’t get that at a traditional payday lender.”

LendUp’s website doesn’t get into details of these superior loans, but Orloff says that the preferred product is a 2% per month interest rate (plus a one-time application fee). Still higher than what you’d have to pay at the local credit union, but obviously far below typical payday standards.

I have little doubt that Orloff is sincere in his mission. Most of his work history involved microfinance, including time spent with both Grameen Bank and The World Bank.

What remains to be seen, however, is if LendUp can really disrupt the payday lending market or if it will simply become part of the broader problem.

For starters, Orloff says that the company’s pre-approval process has resulted in a customer base that is 100% banked. In fact, users need a bank account to receive the loans. So these aren’t the vast underbanked who really need eventual access to those 2% loans. In fact, it’s quite the opposite. If someone has already demonstrated a willingness to walk into a bank and set up a checking account, what is stopping that person from walking into a credit union and taking out a short-term loan at a 6% or 8% APR (as opposed to LendUp’s 180% APR)?

More importantly, however, LendUp is unable learn if a user is taking out a loan in order to pay off a prior payday loan. Or if it’s taking out a payday loan elsewhere to repay its LendUp loan. This phenomenon, which author Gary Rivlin refers to as “payday pinball,” is at the heart of why many payday critics believe the industry fosters a cycle of indebtedness.

“Credit reporting laws prohibit us from accessing that type of information,” Orloff says. “Pulling someone’s credit report can affect their credit history, so we cant do that except at the point in which they are applying for a loan with us. To be honest, it is something we would love to know.”

So, for now, it seems fair to say that LendUp is a better product than the traditional payday loan. At least for those who qualify. Time will tell if the improvement is incremental or disruptive.

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