New Perspectives on Lending

The effects of the pandemic have left a lasting impact, prompting traditional financial institutions to adopt digital banking solutions to better serve their clients. Customers have become accustomed to managing their finances through mobile devices, making it easier to open deposit accounts through applications. However, securing credit remains a more complex process. As mobile technology has advanced, traditional loan products have been hindered by high approval requirements, paving the way for innovative lending alternatives.

Many millennials and Gen Z individuals grew up during the aftermath of the 2008-2009 Financial Crisis, witnessing their families struggle with debt and financial instability. These experiences have instilled in them a cautious approach towards credit, leading to a preference for debit card usage and minimal credit profiles. Consequently, today's consumers are seeking lending products that enhance purchasing power and build credit ratings without incurring additional debt through fees or high-interest rates. The banks and fintech firms that can meet this demand stand to capture significant market share in the upcoming years.

The Challenges Facing Lending-as-a-Service

Given the potential for customer engagement, one may wonder why financial service providers are not integrating LaaS alongside Banking-as-a-Service (BaaS). The complexities of licensing, compliance, and increased costs, which are often passed down to platforms and users, create barriers to offering comprehensive solutions. In the BaaS model, partner banks are generally willing to leverage their national charters for a limited range of use cases, focusing primarily on payments and deposits, with reduced financial risk exposure.

On the other hand, the licensing requirements for lending are considerably more stringent—each U.S. state has unique regulations governing the approval, issuance, and servicing of loan products. Additionally, a range of federal regulations, such as the Fair Lending and Equal Credit Opportunity Act, safeguards consumers from discrimination in lending decisions. Complaints regarding fairness can trigger regulatory investigations and penalties, including fines or program termination.

With heightened regulatory scrutiny, compliance management must address banking risks and broader financial liabilities, such as losses from credit provision. This necessitates increased overhead costs, including the upkeep of in-house legal and compliance teams to stay abreast of state and federal changes. Lending platforms must navigate these challenges independently or collaborate with seasoned, licensed providers.

Moreover, additional capital is essential for issuing loans or credit cards. Banks involved in BaaS partnerships are not structured to provide funding for newly launched programs. Companies are faced with either self-funding or partnering with a capital source, such as private funds or another bank, to secure the necessary loan reserves. This dual challenge of obtaining initial funding for loan products and capital for loans is particularly daunting for emerging startups or established platforms testing new concepts.

Trends Shaping the Future of LaaS

Despite the challenges and costs associated with consumer and business lending, several factors are driving the industry toward diverse lending options. Key influences include:

Small Business-Focused Enterprises

There remains a significant gap in business credit availability. Financial institutions often shy away from lending to small businesses lacking a two-year revenue history. Established eCommerce and payment companies are stepping in to fill this void, offering working capital loans, equipment financing, and lines of credit.

Major players such as Amazon, PayPal, Apple, and Square are now providing these lending solutions. They leverage user data from transaction histories to make rapid lending decisions. Businesses already trust these firms to facilitate sales and payments, allowing approved loans to be disbursed within minutes.

Unemployed individuals have also transitioned hobbies into side gigs, generating new income streams to cover monthly costs. This segment continues to thrive, with many freelancers and creators moving away from conventional employment. Flexible income solutions through alternative lending products are essential for these small enterprises.

Embedded Credit Solutions

The integration of credit into mainstream financial services is becoming increasingly common, particularly through payroll API providers. Employees now have multiple options for accessing earned wages before traditional payroll cycles.

For instance, gig workers for companies like Uber and Lyft can receive instant payment for completed rides, albeit for a fee. Marketplace platforms, such as eBay and Mercari, offer similar services to sellers after payment confirmation.

The Buy-Now-Pay-Later (BNPL) model has gained traction across numerous eCommerce platforms, with providers like Affirm, Klarna, and AfterPay allowing interest-free installment options without rigorous credit assessments. Established credit card companies, including JPMorgan Chase and American Express, are also adopting similar post-purchase installment plans.

Tech-Savvy, Debt-Averse Consumers and User Experience

Millennials and Gen Z are increasingly utilizing mobile shopping applications that include embedded payment and credit features. These demographics are generally wary of traditional credit due to the risk of incurring debt, often resulting in weak credit profiles necessary for large purchases.

For younger generations facing employment challenges during the pandemic, maintaining a bank account can incur unnecessary fees due to monthly balance requirements. As a result, users are flocking to fintech solutions that offer no-fee services and improved user experiences. The combination of debit-like credit cards and loyalty from digital banks presents a significant opportunity for fintech companies to enhance customer satisfaction through innovative credit products.

This trend has also extended to lending for automobiles and homes, with companies like Rocket Mortgage rivaling traditional banks in loan volume. Prospective borrowers can obtain quotes and pre-approval letters in a matter of minutes, streamlining the process compared to traditional methods requiring extensive documentation and in-person meetings.

The Role of AI and ML in Lending

The availability of vast data sets is transforming underwriting practices in lending. By leveraging artificial intelligence (AI) and machine learning (ML), fintech lenders can enhance approval rates while minimizing default risks. These advanced systems go beyond typical income and credit score assessments, offering deeper insights into targeted user demographics and specific lending scenarios.

Data derived from bank transactions, educational backgrounds, and employment histories is shaping a new landscape in lending. This innovation has led to improvements in digital credit cards, business loans, and home lending experiences. Companies are increasingly developing in-house data capabilities or collaborating with data aggregators to invest in new AI models that reduce operational costs and foster growth. A well-performing loan portfolio lays the groundwork for sustainable long-term success for digital lenders.

How Lending-as-a-Service Can Advance

State-level regulatory reforms could mitigate risks for newcomers to the lending sector. Due to the discrepancies in allowed annual percentage rates (APRs) and fees across states, creating uniform national pricing models with profit potential is challenging. In some states, the maximum APR does not suffice for a viable product when accounting for program fees and capital costs. Additionally, varying requirements, such as income verification and spousal consent, complicate the application and approval processes. While achieving a unified regulatory stance may not be imminent, establishing general guidelines could represent a positive step forward.

Tied to regulatory compliance, the elevated costs associated with launching lending products also present barriers. Companies need to either secure their own lending licenses or partner with licensed providers willing to act as the lender of record. In certain jurisdictions, servicing licenses may also be required, adding further time and expense to product launches. Current LaaS providers fulfill most product and compliance needs, but they typically lack debt facilities or capital partnerships. Overall program costs can start at $750,000, which may be prohibitive for new startups or companies exploring market entry.

Best Approaches for Founders and Product Leaders

Instead of seeking funding for both program costs and capital for lending, many companies are entering the lending space with offerings secured by the borrowers themselves through refundable security deposits. Secured credit cards and credit builder loans cater to users with limited or no credit histories. By reducing underwriting requirements, these products can boost approval rates. The deposit made at approval or loan commitment acts as the credit limit, with monthly payment histories reported to credit bureaus to aid in credit score improvement. After a period of 6–12 months of consistent payments, users can transition to unsecured credit products and have their initial deposits returned.

Companies only bear the program costs in secured credit products, as users fund the loans. This user growth and activity can provide validation for potential capital partners interested in supporting unsecured offerings. The competition in this niche is fierce, with financial institutions and large fintech companies like Chime vying for market share. Ultimately, differentiation through added services, rewards, and targeted user groups (such as immigrants, new businesses, or young adults) can drive traction during the initial launch phase.

In summary, the recommended strategy for startups lacking funding, capital partnerships, or expertise in credit is to pursue a secured lending approach. The unsecured route comes with numerous challenges related to funding, credit modeling, and licensing, which are often easier to navigate once a company has established a customer base in the market.

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