7 Ways that Interest Rates Will Impact FinTech and Financial Services

As the Federal Reserve continues to aggressively raise rates to stem the rising tide of inflation, financial services will likely experience a tectonic shift driven by a change in the conditions that have defined the past decade. These conditions — notably the availability of cheap capital, easy credit, and surplus savings — led to the explosion of several large FinTech categories, including BNPL, bank challengers, retail brokerage, crypto, and embedded lending. We are beginning to see these fault lines emerge: Layoffs at Stripe and Chime; a valuation reset at Klarna, MoneyLion, Dave, and Opendoor; and the implosion of FTX and BlockFi. The impact is direct, variable, and extreme.

Financial Services: The Capital Reset

Increasing interest rates are fueling a growing divide between models that have been reliant on cheap cost of capital to maintain business operations and fuel customer growth and those that can leverage yield for sustainable income. We believe rising rates will likely impact different areas of financial services in materially distinct ways. Below are seven scenarios that have the potential to reset the market in the next 6 months and give rise to a new set of “winners” and “losers.”

1. Real Estate Market Freezes Over: With the average 30-year fixed mortgage rate in the U.S. reaching a 20-year high (7%), real estate transactions are set to grind to a halt. Real estate transactions have hit a 28-month low in Q3 ’22, reflecting an (unsurprising) diminished appetite among consumers to transact and take on new, high-interest rate mortgages. While this reduction in demand will likely drive down housing prices, the corresponding reduction in supply may cushion an otherwise painful crash. Regardless of where prices go, the dramatic slowdown will create headwinds for lenders, mortgage originators,and other transaction-based businesses. The public markets have already reacted as at-scale challengers saw a significant valuation reset and we expect to see the same play out in the private markets.
2. ARMs Go Nuclear: In mid 2022, adjustable rate mortgages made up nearly 10% of all new mortgage applications, the highest since ’08 and up nearly 300% since 2020 (source). While this growth is unsurprising in the current economic climate, what is worrisome is the volume of ARMs that are set to expire in the coming 18 months. 5/1 ARMs that were issued at an average rate of 3.25% in 2017 represent $93B in value. With rates more than doubled, there is a risk that a meaningful percentage of these consumers will be unable to meet newly adjusted mortgage payments.
3. BNPL Implodes: Increased cost of capital, a shift in consumer spend from discretionary to non-discretionary, and tighter credit standards will likely squeeze the BNPL market. Faced with higher rates and slimming margins, BNPL players will have to mark-up their pricing to merchants. The increased cost of acceptance could begin to exceed the marginal benefit of greater conversion — tipping the scale and making it unattractive for merchants to adopt and promote BNPL. At the same time, a weakened US consumer base will force BNPL lenders to tighten credit standards, reducing the number of people who qualify for the offering. While tighter credit standards will enable pay in 4 players to avoid major delinquencies, longer term players will likely face delinquencies on their long-duration loans. The secular shift from discretionary to non-discretionary spending could drive reduced demand for BNPL, with over 30% of consumers utilizing BNPL to finance purchases they wouldn’t otherwise be able to afford (source). Given these changes, we expect that BNPL will shift from a “no-brainer” to a more nuanced/difficult decision for many retailers.
4. Credit Desert — A Growing Gap Between Demand and Supply: The CPI index has risen 8.2% over the last 12 months (NSA), and consumers have felt the impact. This quarter, the average interest rate on credit cards reached a 28-year high, at a whopping 18.43% — the highest since the Fed began tracking in 1994 (source). As average Americans will be forced to borrow more money to cover basic expenses at higher costs, we expect to see a substantial increase in the demand for credit. At the same time, tightening underwriting standards may reduce the availability of credit — especially for those who need it most. Lenders with a largely prime customer base will benefit from increased net interest margin. Lenders with subprime customers will likely pull back lending volume — or face the risk of increasing delinquencies.
5. What ReFi Market?: Arguably the most unsurprising casualty in this climate is the ReFi market. Fewer than 1 million residential refinance mortgages were issued in the second quarter of 2022, the lowest in 36 months (source). This trend is not exclusive to mortgages. In Q2 ’22, SoFi reported that its student loan refinancing business had been at less than 50% of pre-COVID levels for the last two years. With student loans increasing more than 33% in the past year, refinancing volume will plummet even more dramatically in the new year. Interest rates for auto loans have similarly jumped nearly 15% YoY, which will likely result in diminished demand for refinancing services.As this trend continues, ReFi start-ups may be hit especially hard as demand for refinancing will retrench in the face of high and rising interest rates.
6. FinTech Challengers in Retreat: Faced with a less friendly private market environment and an existential need to continue to spend more money on customer acquisition, FinTech challengers are facing growing headwinds. Less private capital and stale (artificially high) valuations will make it harder for venture-backed FinTech challengers to raise equity dollars. As access to capital constricts, challengers will face growing difficulty funding customer acquisition and sustaining user growth. Challengers that relied on cheap credit facilities (e.g., alternative/ embedded lenders, etc.) may be underwater on their unit economics and forced to pivot into new business models or seek unattractive exits. Consumers will likely pull back from the products that have defined challenger growth over the past several years — as a decline in artificially high savings rates will drive a shift away from retail brokerage, debit and alternative providers towards more mainstream credit and bank providers.
7. Good to Be a Big Bank: Large incumbent banks are well-positioned to not only survive, but thrive. While certain business units (e.g. investment banking) will be hit, other areas like unsecured credit, consumer banking and transaction services will likely see growth. We have already seen several large institutions outperform expectations in Q3, driven by increased net interest income especially in consumer banking.

The impact of increasing rates is usually not felt until several quarters after the hike is announced. Given the likelihood of additional (albeit smaller) rate increases by the Fed, we believe that the full extent of these seven scenarios will not be known for several months — possibly longer. The first half of 2023 will likely see a continuation of the ambiguity and volatility that has marked the market over the last months. For some, this will create significant pressure and headwinds — especially as funding resets to a new normal. For others, it will create meaningful opportunities to acquire new customers, enter new segments, and take advantage of lower valuations to drive expansive M&A.