SECTOR SPOTLIGHT is a monthly series on FinTechtris exploring a niche sector within FinTech, by defining its history, frameworks, business model, leading companies, and outlook.

Advances in financial technology (or FinTech) greatly impacted today’s digital banking. We see it in the latest features and capabilities from established banks (i.e. Bank of America, JPMorgan Chase). We’ve seen it in the increased competition from challenger banks and neobanks over the last 6 years — openly offering financial services to unbanked and underbanked.

The same movement is emerging with lending. Banks offer traditional products (credit cards or personal loans) within certain risk-based underwriting criteria, specifically credit score and income. Numerous customers (including their own clients) struggle with credit and may not qualify. FinTech Lending 1.0 (the first group of non-bank, digital lending platforms) offered improvements in risk modeling, but with similiar products. For many, the challenge of improving their credit history through utilizing new credit lines, leaves them with no other options.

A new group now follows with FinTech Lending 2.0, which directly targets consumers struggling with credit. New offerings and business models in the last 3 years help customers minimize the need for traditional loans or credit cards, expensive payday lending, and provide a path to build (or establish) strong credit profiles. This Sector Spotlight focuses on the progression of FinTech Lending (from 1.0 to 2.0), opportunities being captured, and what’s ahead.

What is FinTech Lending?

FinTech Lending leverages data, technology, machine learning, and marketing to better identify, underwrite, and serve customers.

In the past (2005 - 2015), the combination was groundbreaking and swept across the industry. In today’s landscape, its the foundation for all new products in the lending sector.

The original FinTech lending company debuted over 15 years ago. This group included Zopa, Prosper, LendingClub, and PayPal. More familiar names were added after 2010, such as Square and Amazon. The focus was on marketplace lending for consumers or small and medium-sized business loans.

This first group of digital lenders focused on the customers just outside the risk model of large banks, due to credit score, income, or years in business (for new companies or business owners). Personal loans, credit cards, and lines of credit were the standard products being offered.

GROWTH IN the FINTECH LENDING sector

This sector quickly expanded across the industry throughout the 2010s. About 40% of lending came from fintechs in 2018, growing 5% since 2013. This explosion in growth is attributed to:

• Data volume: The massive influx of data gave FinTechs large warehouses to build and improve lending models. These repositories included credit bureau, KYC, biometric, phone, social media, and bank data. Assessment of credit risk no longer needed to focus only on credit score and income;

• Machine learning (and artificial intelligence): The application of data science in financial services dynamically improved underwriting models by leveraging alternative data. Processing vast amounts of data via the cloud provided more speed in credit decision and approvals;

• Technology infrastructure: B2B banking infrastructure providers streamlined the implementation and launching of lending platforms, optimizing for time and operational cost. Loan management and servicing wasn’t required to be built from scratch or maintained in-house — functions were outsourced to vendors, or bundled with all-inclusive program providers. FinTech lenders were able to completely focus on customer value and acquisition;

• Targeted marketing: The latest digital marketing practices and distribution made it easier to identify and acquire customers. Instead of partnering with traditional banks through referral programs, fintech lenders advertised directly to their target users and focused on increasing conversion;

The combination of data, technology to process the data, better underwriting models and marketing — lowered the cost and overall risk for FinTech lenders. The result: breakthrough year-over-year growth in users, transaction volume, and profitability. It was now large banks looking to partner with these new lenders.

new strategies in FinTech Lending 2.0

At the end of the 2010s, there was a new group forming in this sector. This new cohort of FinTech lenders (2.0) is designing the next generation of products (more customized and low-cost) and business models (able to de-risk borrowers even further). The same data, infrastructure, marketing tools, and underwriting capabilities are now easily available and accessible to all credit providers. Where’s the competitive space for differentiation now?

With FinTech Lending 2.0, the guiding force is in reducing credit risk from potential borrowers by enabling lower customer default rates. Less defaults allows lenders to provide more credit to a larger demographic of users and at a faster pace. The latest digital lenders are reshaping the industry with these new strategies:

Purpose of Financing: Each approved loan is now for a single-purpose, not for general use.

• The first generation of FinTech lenders provided open access to a pool of credit, and asked for timely payment in return. Not all customers are able to manage an open credit line, leading to default and a negative impact to credit history. New lending platforms approve loans against incoming invoices (i.e factoring), consumer purchases at point-of-sale (e.g. Buy Now Pay Later lenders), or for specific business uses (such as new business equipment).

Improving repayment behavior: Using auto pay to increase likelihood of repayment, instead of standard billing.

• This is a user experience play (e.g. make things easier for customers) that can also reduce default risk. A borrower commits in advance to having their monthly payment deducted automatically from their bank account. This date can align with their pay period to ensure enough cash flow on hand. Even though this behavior can be encouraged by lenders, it can’t be made mandatory (based on lending regulations which vary state by state).

Partnerships for new customers: Affiliate relationships with B2B platforms can provide access to strong borrowers.

• There are synergies between lending platforms and specific customer niches, such as employers with employees, insurance companies, and other close-knit communities. These groups access additional benefits from the loan product and the lender minimizes their cost of acquisition in gaining credit-worthy applicants. Lenders can go as far as customizing offerings for specific markets (e.g. pricing, perks, access, marketing) to build a stronger connection to that particular community.

Offering different incentive structures: Loans and repayment are tied only to borrower outcomes or specific events.

• Certain types of financing are outdated and in need of restructuring, specifically with education and home ownership. New programs exist in which platforms essentially invest in the borrowers success. Instead of standard loan offerings, equity agreements are being used with terms of repayment based on events such as finding a job or selling a home. Many schools have started to offer Income Share Agreements (ISAs) instead of expensive student loans that start billing after graduation.

Connecting usage to repayment: Borrowers in default would no longer access the asset/benefit being financed.

• This model has existed for some time with cars and loans — repossessions or foreclosures can take place in the case of default. In FinTech Lending 2.0, the scope has narrowed to smaller purchases that customers heavily rely on, such as mobile phone financing (which can lock your phone due to non-payment).

New lines of business: Existing platforms with users are adding lending products.

• Companies with large user bases (such as social media, eCommerce, or payroll platforms) have an extensive relationship with their clients. The amount of data on customers can help build a lending solution with custom user benefits and no customer acquisition cost.

As FinTech Lending continues expanding, more strategies may emerge based on regulation or the latest industry innovation (i.e. decentralized finance, or DeFi). Much of the growth is also propelled by consumers demanding new products and ways to build, establish, or maintain credit while avoiding debt. Some of the up and coming platforms (listed below) are delivering exactly on this customer need.

Emerging FinTech Lending categories and companies

New business models, increasing investor appetite, consumer demand, and niche-based trends have created the current climate of lending platforms and products available. Here are the various categories and companies driving FinTech Lending forward this decade:

EMERGENCY CASH ADVANCE: For a monthly subscription fee, consumers have monthly access to advances (from $100 - $500, but some can go up to $1K). The advance is a non-recourse disbursement and needs to be repaid as a lump sum on a customer’s next pay period (in 1 - 3 weeks). There are no additional fees or interest charged to the user; the platform decides on access to the advance based on a user’s income and banking history. Platforms include: Brigit, Dave, Earnin;

PAYROLL ADVANCE: Similar to cash advances, platforms partner with employers to offer employees access to earned wages before the end of a paycycle. Instead of an employee sending a payment later, their next paycheck would have the difference already calculated in the net proceeds received. Platforms include: PayActiv, Even, HoneyBee, FlexWage;

BUY NOW PAY LATER: These platforms gained popularity in the last 2-3 years as a point-of-sale (POS) financing option, without fees or interest paid by the consumer. Installment loans are approved based on the purchase, and repayment is typically split into 4 equal payments (debited every few weeks). Platforms include: Affirm, AfterPay, Klarna, Sezzle;

INVOICE FINANCING FOR CREATORS: Digital creators and influencers work with brands to promote content. Payment terms can be 30 - 90 days, based on the amount and key performance indicators. Invoice financing allows creators to access future cash inflows early to cover working capital needs. Platforms offering this type of financing typically look at contracts, past usage metrics, and performance history for underwriting criteria. Platforms include: multiple startups (none are live) are launching in 2021;

The home lending vertical is also experiencing new models and products allowing for consumers to purchase homes with less friction. We covered last year what companies such as Unison and DivvyHomes now offer to the new generation of prospective homeowners (here).

looking ahead at what’s next

The shift in lending from traditional bank options to FinTech Lending has had immense global impact. Similar to banking services, consumers no longer need to turn to financial institutions to address their credit needs. FinTech lending has absorbed the legacy bank model into a faster, customer-friendly process with a higher likelihood of approval. The next development brought lending directly to the consumer — embedded options at point-of-sale, at the workplace, in their paycheck, or at school.

The trend we will continue to see is the lending sector iterating upon itself — faster, more customized, lower risk, minimal cost solutions based on better underwriting models and increased connectivity. Payroll, banking, and tax accounting will form a user data profile that the next generation of FinTech lending utilizes.

Consumers and businesses will clearly know before applying what the specific offer (and cost details) will be from competing lenders. This transparency leads to increased consumer confidence and even more growth going forward.

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