For years, the financial technology industry has promised to identify good credit risks that big banks and traditional lenders might miss, providing people with affordable loans they might not otherwise be able to access. However, research is indicating that the fintech hype is not living up to that promise.
According to a working paper distributed by the National Bureau of Economic Research, technology companies and startups in the fintech world “rely heavily” on credit scores to price their loans and don’t incorporate other variables that could better predict default. As a result, fintech clients and customers with nonprime credit scores pay interest rates that are 45% more expensive than those of prime borrowers who are also at risk of default.
Lenders have relied on credit scores from companies such as FICO for decades to evaluate the risk of default. Recently, consumer advocates and lawmakers have criticized these formulas for including variables that could lead to discrimination. As a result, these credit scores aren’t an accurate predictor of borrowers’ risk and are particularly faulty when it comes to low-income borrowers and borrowers of color. In response, fintech lenders have begun using artificial intelligence and other tools to bring in a wider swath of data and identify good credit risks where traditional lenders would not. Fintech Companies Charging Risky Borrowers More: Study
A recent study has revealed that some fintech companies might be charging higher interest rates to borrowers who have historically been seen as too risky for traditional lenders. The study’s findings suggest that such borrowers could end up paying $500 more on average in the first year of their loan than those who pose a similar level of risk. These extra costs can hit those with the tightest budgets hardest, according to experts.
Whilst fintech firms have received praise for using big data and AI models to decide whether to lend money to people, this research certainly suggests that there might be cause for concern in how they are charging customers. To conduct the research, the team analysed data from some of the leading fintech personal loan originators, such as SoFi, Lending Club, Upstart and Prosper. The names of specific firms within the dataset were not disclosed by the researchers. It’s crucial that fintech companies ensure their lending is fair and doesn’t place an undue burden on those most in need of a financial boost.
Fintech Lenders’ Pricing Strategy Falls Short
Economists at the Securities and Exchange Commission, Georgia State University and Ohio State University recently conducted a study on how sports gambling impacts people’s use of debt. However, what caught their attention was the significant increase in interest rates borrowers faced when their credit score fell below the 660 threshold – the cut-off for prime credit scores.
The researchers were surprised that borrowers with FICO scores of 659 were treated the same as those with FICO scores of 660 despite the minimal difference in risk. This finding challenges the argument made by fintech lenders that their loan pricing strategies are informed by more than traditional credit scoring.
The Truth About Fintech Lender’s Promise to Bring Financial Inclusion
Fintech lenders have promised to bring traditionally underserved individuals into the financial system, but is that really the case? Recent research has found that these companies are engaging in a little bit of regulatory arbitrage rather than expanding access to credit.
The Problem with Fintech Lenders’ Business Model
Fintech lenders typically make loans and then sell them to other institutions. However, due to regulation, banks won’t buy loans made to borrowers with credit scores below 660. As a result, hedge funds or other investors must take on these loans and require higher returns, resulting in higher interest rates.
According to Johnson, interest rates aren’t determined by risk, but instead by market forces outside of fintech’s modeling. Marco Di Maggio, director of the Fintech Lab at Harvard Business School, argues that this contradicts fintech lenders’ promise to bring underserved individuals into the financial system.
A Little Bit of Regulatory Arbitrage
Many fintech lenders rely on regulatory arbitrage by getting funding from banks, doing riskier loans, securitizing these loans, and selling them to investors. While everyone in the system benefits from these new companies, they’re not really achieving financial inclusion.
The Hope for Fintech
In conclusion, there is still hope for fintech lenders to deliver on their promise of financial inclusion, but they must address their business models and ensure they are truly expanding access to credit for all individuals.
Upstart’s Innovative Approach to Nonprime Consumers
However, Jonathan Zinman’s research on fintechs like Upstart does not contradict these findings. While Zinman agrees that the Upstart model is different, he suggests that a broader picture of other fintechs is necessary to fully understand the industry.
Upstart’s co-founder and CTO, Paul Gu, confirmed that his company’s model is indeed unique. It doesn’t rely heavily on traditional credit scores when assessing borrower risk and determining loan rates, unlike most other players in the industry.
Although borrowers with low credit scores may pay higher interest rates than their higher-scoring counterparts, Gu notes that Upstart borrowers with credit scores of 650 and below are more likely to pay interest rates higher than 30%, a rate relatively low compared to traditional lenders.
Overall, Upstart’s innovative approach to nonprime consumers allows for more individuals to access credit at better rates. And while its model may differ from other fintechs’, it is certainly one that many hope will be embraced by the industry moving forward.
The Limitations of FICO in Assessing Risk for Borrowers
The credit score known as FICO remains a significant factor in evaluating the creditworthiness of a borrower. However, recent studies conducted by researchers at Stanford Business School revealed that FICO’s application does not entirely determine the borrower’s risk as it is just one of the many inputs calculated by online lenders such as Upstart.
Borrowers with equally similar FICO scores can receive varying and often lower rates from Upstart due to its distinct input methods. Di Maggio, one of the researchers, said that while higher FICO scores are still correlated with low risk, nonprime borrowers can still receive favorable rates from this fintech lender.
The research carried out by Di Maggio and Johnson discovered that demand for loans from borrowers of good credit standing is largely unmet, particularly in cases where traditional lenders disregard them because they have low credit scores. According to Johnson’s study, these borrowers pay more for their debt than they would if they were evaluated based on the risk of default alone.
Bruckner, an analyst on fintech lending space, observed that people who share similar economic status often receive different loan rates. Currently, there is no clear regulatory solution to address this problem. Since online lenders are monitored by various entities like the Consumer Financial Protection Bureau and federal trade commissions, Bruckner suggests that continuous monitoring can help identify major problems and solve them without necessarily making permanent binding rules.
Fintech Companies Face Pushback Against Interest Rate Caps and Regulations
Fintech companies have historically resisted proposals that would impose interest rate caps and regulations similar to those required of traditional brick and mortar banks. Recently, some of these companies have criticized a law passed by Colorado legislators that requires fintech lenders partnering with out-of-state banks to comply with the state’s interest rate cap when lending to Colorado borrowers. The goal of the law is to prevent fintech lenders from charging interest rates that are higher than what is allowed in Colorado by using out-of-state banks with higher or no interest rate caps.
While some fintech companies reason that lighter touch regulations could provide access to lower cost credit for people with lower credit scores, a recent study conducted by Professor Aaron Johnson suggests otherwise. Ellen Harnick, Executive Vice President for the western region at the Center for Responsible Lending, states that “What this paper indicates is that in general it’s simply not true.”
Consumer advocates have raised concerns that some of the alternative data used by fintech lenders could reproduce racial inequalities. Harnick explains that there is a risk that these algorithms may unfairly benefit some individuals while disadvantaging others, particularly along racial lines. While more sophisticated models could increase access to credit for those who have traditionally been underserved, caution is necessary.
In summary, fintech companies must grapple with balancing access to credit and fair practices with potential risks of replicating inequalities.