Fintech reportedly is allowing lenders to close on mortgage loans faster than in the past, and, especially as the market shifts increasingly digital, all signs point to its growth in mortgage lending. Researchers have found fintech lenders tend to take on certain risks that traditional lenders do not—though, for a few reasons, this is counterintuitive—leaving fintech loans more likely to default.
Conventional wisdom suggests that fintech lenders gather better-rounded, deeper insight into applicants banks might reject following a standard credit check, wrote Harvard Business School's Rachel Layne. She continues, "Fintech lenders claim to consult additional metrics like utility bills or rent payments to identify creditworthy individuals that are overlooked by traditional lenders." She sourced a research paper by Harvard's Marco Di Maggio, Associate Professor of Business Administration, and Georgia State's Vincent Yao, in which the authors compared unique individual-level data covering fintech and traditional lenders.
Di Maggio expounded, "If you put [our] results into the context that most of the fintech companies assertion that they use alternative data, it’s very surprising that their borrowers are more likely to default." Still, as Layne sums it up on Harvard's Working Knowledge blog, data in the "Fintech Borrowers" study show that "consumers who turn 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."
While researchers focused heavily on the personal credit market, they studied all types of loans; the authors cited mortgage market studies while, overall, tracking 3.79 million loans for 1.88 million borrowers.
The researchers added a potential upside for fintech lenders: "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."
Beyond paperwork, and possibly the number of factors underwriters observe, what other differences in these two types of lending affect risk?
Fintech lenders might be able to operate where the banks do not find it profitable, Di Maggio and Yao reported, citing a 2014 Chase annual report wherein the CEO told investors, “There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and—these entities believe—effectively by using Big Data to enhance credit underwriting. They are very good at reducing the pain points in that they can make loans in minutes, which might take banks weeks.”
Researchers turned to their main results and examined whether fintech loans exhibit different performance than loans granted by traditional institutions in the 15 months following origination.
"We find that fintech loans are significantly more likely to be in default...The results are also economically meaningful, they wrote. "In fact, we find that the fintech loans exhibit a 1.1% higher default probability, which is large compared to the sample mean of 1.4%. In addition, the relative underperformance persists for our entire time window starting in month five after origination."
The researchers presented data that they say backs up the idea that borrowers turning to fintech might be disposed to consume or spend more than they can afford (which leads to increased debt and ultimately, default).
"The evidence points out that the increased ease and speed with which borrowers can have access to credit is particularly appealing to certain households who tend to use these funds, in conjunction with other forms of credit, to sustain their consumption, which ultimately makes them more financially vulnerable," the authors said. "These results might also inform the debate about the need to provide clearer guidelines and regulatory scrutiny for those new institutions operating in this market. In the same way in which the Dodd-Frank Act induced banks to be more concerned about the borrowers’ ability to repay, a similar intervention in this unsecured lending market might reduce the negative consequences of granting loans to borrowers who are bound to default..."
The researchers look further at history and policy to anticipate problems their findings would present and possible solutions.
They added that one significant challenge for policy makers is that, "Curbing the credit provided by fintech lenders could negatively impact the most credit-constrained borrowers."
However, they continue, "in the same spirit as regulators introduced the 'ability to repay' rules for mortgage products in the aftermath of the subprime crisis, one dimension of interest for regulators might be the need for fintech lenders to more closely monitor the borrowers’ ability to service their unsecured debt and the way these additional funds are actually used by the borrowers."