Consumers turning to fintech lenders are more likely to
spend beyond their means, sink further into debt, and ultimately default more
often than people with similar credit profiles borrowing from traditional
banks, according to recent research.
The study, Fintech Borrowers: Lax-Screening or Cream-Skimming?,
was written by Marco Di Maggio, the Ogunlesi Family Associate Professor of
Business Administration at Harvard Business School, and Vincent Yao, an
associate professor from Georgia State University’s J. Mack Robinson’s School
of Business.
The findings run contrary to conventional wisdom that
fintech lenders harvest deeper insight into those borrowers that banks
typically reject after running a standard credit check. Fintech lenders claim
to consult additional metrics like utility bills or rent payments to identify
creditworthy individuals that are overlooked by traditional lenders.
“If you put the results into the context that most of the
fintech companies claim that they use alternative data, it’s very surprising
that their borrowers are more likely to default,” Di Maggio says.
Di Maggio and Yao tracked 3.79 million loans for 1.88
million borrowers using detailed national data from one of the three major
credit reporting agencies over several years. This offered an in-depth look at
borrowers that either used a fintech company or a bank to obtain a personal
loan. (A personal loan is an unsecured loan that is usually provided to
consolidate existing higher-cost credit card debt.)
That’s a far more extensive sample of consumer credit
behavior than previous studies, which tend to focus on data from a single
fintech lender like LendingClub and provide no bank comparison. The authors
then tracked performance of all borrowers’ loans from four months before the
personal loan origination up to 15 months after.
“FINTECH BORROWERS ONLY PARTIALLY CONSOLIDATE THEIR DEBTS,
AND THEN A FEW MONTHS DOWN THE LINE, THEY KNOW THAT THEY HAVE THESE CREDIT
CARDS THAT ARE EMPTY AND THEY START USING THEM AGAIN.”
In a nutshell, fintech borrowers who initially improved
their credit scores by consolidating some of their credit card debt saw a
deterioration in those scores months down the line as they began to use their
credit lines to consume more goods, from purchasing a car to buying everyday
items, the researchers found.
By a year after the fintech loan, more than 5 percent were
likely to default. That’s a 25 percent increase in risk of default compared to
similar bank borrowers.
“Fintech borrowers only partially consolidate their debts,
and then a few months down the line, they know that they have these credit
cards that are empty and they start using them again,” Di Maggio says. “And so
leverage starts ramping up again, but now they have to repay both the credit
card debt the personal loan, which cause their defaults to skyrocket.”
This type of behavior is less likely among bank borrowers,
suggesting that fintechs attract a different type of loan-seeker—one with a
higher propensity to overspend—which is not something easily captured in their
credit reports.
The rise of fintechs
Fintech lending’s popularity exploded in the years following
the financial crisis a decade ago. A rising number of them originated $3.79
billion in loans in 2017, an eight-fold increase from 2013, the researchers
note.
That surge, analyzed before the onset of the pandemic, was
expected to rise even more by the end of 2020, driven partly by the premise
that fintech companies can take advantage of being subject to less regulatory
scrutiny and investors’ appetite for high yields.
But even with more defaults, fintech lenders weren’t likely
to be hurt, in part because the companies charge higher rates commensurate with
higher risk. Borrowers with “thin” credit files, for instance, were charged a
premium of 5 percent more compared to what banks charge for similar borrowers,
the researchers found.
But there’s an upside for fintech lenders, too. Their
borrowers tend to be loyal, take out more loans over time, and are apt to get
additional credit when they need it most, such as after a job loss, research
suggests. That presents a quandary for policymakers, Di Maggio says.
Fintech companies bundle loans and sell them to other
investors, much like the real estate loans that helped propel the financial
crisis.
A tool similar to the “ability to repay” requirement introduced
by the Dodd-Frank Act for fintech lenders might serve the industry well, Di
Maggio suggests. The law “forced the banks to actually make sure that the
borrowers will be able to repay their loans.”
“In the mortgage market, there are all these tests about
debt-to-income ratios,” he says. “Fintech lenders that give you these types of
unsecured debt are not forced to do something like this.”
What consumers can do
As for consumers, Di Maggio advises to watch spending
carefully, or things can quickly get out of control.
“Probably the biggest challenge is making sure that you're
using the fintech personal loan for the right reason,” Di Maggio says. “This
type of loan needs to be used as a consolidation tool or as a bridge loan to
meet a specific, temporary need.”
The loans should not be used to finance consumption.
“Otherwise,” Di Maggio says, “it is likely you will end up overspending or
overstretching yourself, and then more likely to be in default which will cut
you out of the credit market altogether.”
Fintech companies, many of which have operated only during
an economic boom, are likely to suffer now during the pandemic-induced historic
recession as some borrowers struggle to repay and investors buying their loans
become more difficult to find.
“Many low-profitability, high-risk lending companies that
came up in the last few years will likely suffer quite a bit,” Di Maggio says.
For those that were careful in their lending practices during the boom market,
“there's going to be an issue in that the liquidity on the investor side may
dry up.”
Click here
for the original article.