Home » How Can Higher Interest Rates Affect Startups in the Fintech Space?
The macroeconomic environment has changed a lot this year compared to 2021 and even before the pandemic started as inflation in multiple corners of the world appears to be spinning out of control.
This situation has prompted central banks to take hawkish actions including raising interest rates to levels not seen in a long time. For example, the US Federal Reserve raised its federal funds rate from around 0.25% to 3.25% thus far and analysts are projecting that rates could end the year somewhere near 5%.
This is bad news for borrowers as the cost of using debt to finance their purchases has skyrocketed. Meanwhile, for lenders, the situation may not be as black and white since, on one side, they stand to benefit from higher interest income while on the opposite side, they may have to deal with higher levels of delinquencies.
In this article, we explore the impact that higher interest rates could have on the performance of financial technology companies and, more specifically, on early-stage businesses in this space.
One of the immediate concerns for financial institutions and investors is the possibility that default rates could surge among borrowers who hold variable-rate loans as their installments may go up significantly in this environment.
According to data from the St. Louis Federal Reserve, delinquency rates on all consumer loans have been going up since the second quarter of 2021, moving from 1.57% back then to 1.81% by the end of the first semester of 2022.
Even though this percentage is still well below the level seen before the pandemic started – around 2.28% by the end of the fourth quarter of 2019 – the fact that delinquencies are steadily increasing may be a sign that borrowers are starting to struggle to stay current with their financial commitments.
#2 – Interest income could increase
Companies in the fintech space that lend money to customers should benefit from higher interest rates as the amount they will collect from interest payments should go up. That said, even though this is true in theory, the extent to which the company will benefit will depend on the type of loans it has extended and the volume of new business it can bring in.
For example, companies that offer fixed-rate lending products may not benefit at all from higher interest rates except on the new loans they extend at higher rates. On the other hand, if the majority of the loan portfolio is made up of variable-rate loans, the company’s financial performance should experience a significant boost.
One good example of a fintech company that may benefit from this environment is Evest. Through the Evest app, users can have access to margin trading, meaning that they can borrow money to trade stocks. Evest benefits from higher interest rates as it will be charging higher margin rates to its customers.
#3 – Down-rounds and difficulties to secure financing
Higher interest rates typically lead to a decline in the valuation of risky assets including equities. Early-stage businesses may be among the most affected when it comes to obtaining financing from investors as they could be subject to down-rounds.
A down-round is a funding round in which the valuation of the startup has been diminished compared to previous occasions. This situation could force founders to give up more equity to secure the required financing or it could reduce the list of interested investors.
Startups in the fintech space typically require capital to expand their operations. In this particular environment, they could struggle to secure the funding they need unless the business’s growth rates remain appealing to investors.
#4 – Lower demand for loans and other similar products
When central banks start to adopt restrictive measures for their economies, this can cause a slowdown in economic activity that can have a negative impact on household income, employment levels, and corporate investment.
Moreover, when inflationary pressures are high, families tend to reduce their discretionary expenditures to compensate for the higher cost of the goods and services that are considered essential.
The demand for consumer loans may decline in this environment and households may even opt to pay back their most expensive debt to make ends meet. This would cause a drop in the size of the portfolio of interest-bearing loans for fintechs that engage in lending activities and may also reduce their interest income down the road.
What about crypto companies?
Companies in the blockchain and crypto space are typically placed in the same group as financial technology businesses. These startups have faced significant hurdles since 2021 as the value of crypto assets has declined sharply due to both industry-specific developments and a deterioration in the macroeconomic backdrop.
Incidents such as the implosion of the Terra ecosystem and the bankruptcy of several well-known blockchain projects like the Celsius Network and Voyager Digital will probably weigh on the ability of startups in this promising space to raise capital and withstand the turmoil.
It is still too early to tell if the current macroeconomic shift will hurt or benefit the fintech space as a whole as analysts coincide that a recessionary cycle may just be starting for the global economy. What makes the outcome a hard one to predict is that higher rates benefit lenders as long as the demand for loans does not decline too sharply. Will that be the case now? Only time will tell.