Douglas Merrill's sister-in-law Vicki needed new snow tires. Without them, the single mother of three, who was going to school while also working full-time, couldn't get to work. She'd lose her job.

But Vicki was in a bind. She couldn't pull the money together to cover the unexpected expense. So she called Merrill, who gave her his credit card number. As the former chief information officer at Google, he could afford to foot the bill. But he was curious: What would Vicki have done if she didn't have a well-off family member to turn to?

"'I'd have taken out another payday loan,'" Merrill says she told him. "I thought it was unfair that she could call me and other people couldn't."

This is the origin story Merrill tells when asked how someone with his high-end tech credentials wound up starting a company, ZestFinance, to lower the cost of credit for so-called "subprime" borrowers like Vicki. What kind of loans? Payday loans. Kind of. Not really. But really.

Welcome to a complicated new world of smart, well-funded entrepreneurs doing what smart capitalists have always done: ferreting out an underserved market and serving it. But the market these startups have chosen stands out because of how starkly it contrasts with the privileged techie class seeking to profit off it: an industry awash in money deliberately targeting people who decidedly aren't.

But don't expect any apologies. Merrill and other startup founders like him see the reinvention of the payday loan as more than a good business opportunity. By shining a Silicon Valley-powered light into the dark corners of the financial services industry, they believe they can lift people like Vicki out of a cycle of predatory debt.

In theory, the high cost of a traditional payday loan stems from the greater risk a lender takes advancing cash to someone who can't qualify for other forms of credit. Some critics contend payday lenders charge usurious rates to trap borrowers in a cycle of debt they can't escape. But even lenders acting in good faith can't offer the low rates made possible by ZestFinance's algorithms, Merrill says.

Using data-crunching skills polished at Google, Merrill says ZestFinance analyzes 70,000 variables to create a finely tuned risk profile of every borrower that goes far beyond the bounds of traditional credit scoring. The more accurately a lender can assess a borrower's risk of default, the more accurately a lender can price a loan. Just going by a person's income minus expenses, the calculus most often used to determine credit-worthiness, is hardly enough to predict whether a person will pay back a loan, he says.

"Our finding, much like in Google search quality, is that there's actually hundreds of small signals, if you know where to find them," Merrill says.

For instance, he says, many subprime borrowers also use prepaid cellphones. If they let the account lapse, they lose their phone number. Would-be borrowers who don't make keeping a consistent phone number a priority send a "huge negative signal." It's not about ability to pay, he says. It's about willingness to pay. By examining factors that don't play into standard credit scoring � and are therefore ignored by traditional banks � Merrill says ZestFinance can help bring the "underbanked" back into the financial mainstream.

Currently ZestFinance licenses its technology to SpotLoan, an online lender that offers loans of $300 to $800 at rates it advertises as about 50 percent less than those of standard payday loans. On a recent visit to the site, the standard annual percentage rate (APR) for a loan issued to a California resident was 330 percent – $471 for a $300 loan paid back over three months, the smallest, shortest-term loan the site offered.

By comparison, standard payday loans available online offered APRs of about 460 percent, though the term was just 14 days. The rates on 30-day loans ran a little less than half that. Either way, a $200 loan ends up costing about $235 in financing if paid back on time via the old-school payday lenders.

Merrill acknowledges that ZestFinance-powered loans still aren't cheap.

"We are an expensive loan compared to credit cards or what you can get from your family," he says. "The problem is not everyone can get credit cards, or can borrow money from their family."

Unlike the several traditional payday loan companies' websites I visited, SpotLoan stood out by prominently displaying the payback amount and APR from the outset of the loan application process.

Transparent by Design ———————

LendUp, a San Francisco startup, has made transparency its key selling point. Its website puts sliders front-and-center that let would-be borrowers pick their loan amount and term. A large display recalculates the final payback amount as the sliders move.

Sasha Orloff, LendUp's founder and CEO, speaks Silicon Valley's language of user-centric design. He says walking into a storefront where the borrower is separated from the lender by bulletproof glass doesn't set the stage for a dignified or transparent transaction. From what I saw, neither does a clunky website riddled with PDFs and clumsy forms, which seems standard for many payday loan companies.

"We spend a lot of time designing the experience so (borrowers) know what they're getting into," he says.

Unlike traditional payday lenders, LendUp also takes a big data approach to determining who's at greatest risk for defaulting. While LendUp doesn't dig quite as deeply as ZestFinance, it's still relying on non-traditional signals, from a loan applicant's Facebook profile to whether they pay their utility bills on time.

LendUp's design philosophy reflects Orloff's broader belief that short-term, high-interest loans don't have to be exploitative. In the early 2000s, he rode the rising wave of enthusiasm for microfinance, working with the Grameen Foundation to build software for microlenders. Although he now looks the startup founder's part in company t-shirt and jeans, he also spent years in the world of high finance at Citi, ultimately serving as a senior vice president at Citi Ventures, where he invested in financial services projects. With a background like this, LendUp makes sense as Orloff's next step. By combining a microfinancier's belief in the transformative power of even a small amount of money with a deep knowledge of the calculus of consumer financial services, Orloff believes he can offer what he calls a "dignified alternative" to payday loans while building a successful business.

"I firmly believe we can make more money by creating better value for the customers instead of setting traps," he says. "We think that there's a way to do good by others without going bankrupt."

But is there? LendUp customers can file for an automatic 30-day extension if they can't pay off their loan on time. Customers can't take out a loan of more than $250 until they've shown they can pay off a loan of that size successfully, and they can't roll over an unpaid balance into another loan, the infamous payday loan trap that sends already strapped people into a pit of revolving debt that's practically Sysiphean.

Borrowers can also get discounts on future loans by paying off their first loans on time and by taking an online credit education course. Eventually, they can graduate beyond payday loans to installment loans with better rates. LendUp is also trying to get the major credit bureaus to recognize paying off a LendUp loan as a positive factor when calculating a borrower's traditional credit score � which, if successful, could put that borrower in a position of not needing to borrow from LendUp anymore. Instead, they could just get a credit card from a bank.

Big Data = Better Loan? ———————–

Still, better algorithms, interaction design and customer service don't erase all the concerns of payday loan critics.

On the one hand, says Paul Leonard, who heads up the California office of the Center for Responsible Lending, a non-partisan, non-profit that examines predatory lending, the fact that ZestFinance and LendUp bother to gauge the default risk of borrowers at all shows they're acting in better faith than typical payday lending operations.

"All a payday lender is going to do is verify that you have income and that you have a checking account," Leonard says. "They have a business model that relies on borrowers who can't really afford to repay their loan."

But more sophisticated risk-measuring tools come with their own temptation, Leonard says. They can be used to drive down costs by giving lenders a more accurate way of figuring out who will actually pay the loans back and only lending to them. On the other hand, a lender might decide to play the spread: 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.

To ensure the former happens rather than the latter, Leonard says regulations need to catch up with the technology.

"The goal is to get the maximum amount of responsible and sustainable lending to the broadest population of folks that can qualify for it," he says, and it's up to the government to make sure that happens.

Jeremy Tobacman, an assistant professor at the Wharton School of the University of Pennsylvania, has studied the payday loan industry extensively. His research indicates that the financial straits that force people to turn to payday loans in the first place create a gulf between those borrowers and the financial mainstream that no single loan will likely bridge.

"The differences between payday applicants and the general population are enormous and longstanding," Tobacman says. "Whether or not they get a payday loan just isn't going to make an impact on their financial standing."

In the meantime, a San Francisco-based startup called BillFloat is taking a different approach to serving the payday loan market. Instead of handing out cash to borrowers running late on a cable, cell phone or electric bill, BillFloat partners with companies like Verizon and Comcast to pay your bill for you and give you another 30 days to come up with the money.

BillFloat CEO Ryan Gibert says his company's loans, which max out at $200, don't exceed a 36 percent APR. The much lower cost doesn't come so much from better risk assessment, though that plays a part, Gilbert says. Instead, he says, BillFloat can keep its own costs low because it doesn't have to spend money on getting new customers. Rather than having to advertise, BillFloat just shows up as another option alongside Visa and Mastercard when you sign in to pay your bill.

"It's very noble if someone wants to go and disrupt the payday lending space," Gilbert says. "But if you're going to charge as much as payday lenders charge, you're really not disrupting much."

"A $6 trillion market is big by anyone's math" ———————————————-

However much these startups do or don't disrupt the underlying dynamics of payday loans, they certainly benefit from feeling less seedy. Better web design can do wonders to give the sense that someone isn't trying to rip you off.

And if ZestFinance, LendUp and others really have developed tools to make high-risk loan underwriting smarter, they have potential value well beyond the startup world. ZestFinance CEO Merrill in particular is hopeful that big banks will start to use his algorithms to serve borrowers that less refined data models consider too high-risk.

"That's the winning game. If we can get the banks back into the picture, they have hundreds of billions of dollars in capital to deploy," Merrill says. "That puts up a lot of capital, a lot of pricing pressure that ... will drive the really expensive payday loan people out of business."

Already, banks have shown they aren't blind to the $44 billion payday loan market. After federal regulators cracked down on partnerships between payday lenders and banks, the banks themselves started offering their own payday-style loans in the form of high-interest direct deposit advances, the Center for Responsible Lending says.

Other segments of the financial services industry are also recognizing the value of serving so-called "underbanked" customers, whether in the U.S. or other parts of the world. Ron Hynes, executive vice-president of global prepaid at Mastercard, says some 2.5 billion people globally lack access to basic financial services like checking accounts, debit accounts, credit, and insurance. Though not integrated into the mainstream financial system, they will still spend around $6 trillion annually, Hynes says.

"The need is there. The opportunity clearly is there. A $6 trillion market is big by anyone's math," he says.

For the underbanked market, Mastercard and other credit card companies are focused on the prepaid market, as evidenced by the huge racks of prepaid cards hanging at the ends of the aisles at grocery stores and pharmacies across the country. Prepaid flips the risk equation on its head by making the customer the lender to the prepaid card company, and paying a fee for the privilege.

The kind of underbanked lending enabled by ZestFinance, LendUp and others might start to look like mainstreaming by comparison. But doubts remain about whether improvements in financial services alone can do much to pull people off the financial margins.

"I think the challenge in terms of credit is that being better when the alternatives are so bad may ultimately prove insufficient," says Jennifer Tescher, president of the Center for Financial Services Innovation, a Washington, D.C.-based nonprofit. "The question isn't can you be better � it's how much better."

"These are all worthwhile efforts," Tescher says. "But at the end of the day the proof is in the pudding. These are not fully baked yet."