What do rising rates mean for online lenders?

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The past half-decade has been a gold rush for new online lenders. With banks drowning in regulation and the explosion of big data opening the space to more upstarts, a wave of Web-based lending companies have emerged with the goal of luring more consumers.

The Federal Reserve's zero interest rate policy has also certainly helped. Yield-starved investors desperate for fixed-income returns have essentially played the role of bank roller, pouring money into new lending platforms.

Known as marketplace lenders, these companies originated nearly $9 billion in loans in 2014, up from about $100 million in 2009, according to venture firm Foundation Capital. While some of that money has been funded by banks, the majority has come from private equity firms, hedge funds, family offices and retail investors.

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Now that Fed Chair Janet Yellen has indicated the Fed funds rate will rise above zero for the first time in more than six years, a key question is whether these investors will flock back to Treasurys and corporate bonds, removing tech start-ups' easy money punch bowl.

For now, that's not happening. Just this week, 4-year-old SoFi, which refinances student debt and offers mortgages and personal loans, said it had crossed the $2 billion mark for loans issued. SoFi has enough growth mojo that it's starting a competition whereby it will forgive one student loan—of up to $600,000—per quarter.

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And Upstart, a fresh entry into the online lending market, got a big vote of support from private equity firm Victory Park Capital, which said it's increasing its commitment to finance $500 million worth of personal loans, up from $100 million.

"Their results give us confidence that this emerging [lending] platform is serving a critical market need," said Tom Welch, a principal at Victory Park, in a statement.

Of course, few doubt higher interest rates could eventually hurt these new lenders. Loans are sensitive to rates, so prices have to rise to protect margins. But for now, the demand for marketplace loans is soaring.

Let's dive further into the potential impact of higher lending rates.

Even with the Fed suggesting rates will rise from zero, the average forecast among market participants is that the benchmark rate will reach 0.625 percent by the end of this year and 1.875 percent by the end of 2016.

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Nothing below 2 percent is much of a concern, says Peter Renton, founder of industry publisher Lend Academy. For lenders that are taking borrowers out of debt at 20 percent interest and are consolidating them into loans at rates of half that amount, the remaining spread offers plenty of profit on the table for investors.

Another reason new lenders can be confident in a higher interest rate market is they've got a backlog of potential customers. SoFi and others are proving they can make money for investors while simultaneously attracting a new generation of borrowers who want to avoid traditional banks.

"I don't think for the next year if rates back up 100 basis points it will have much impact across the landscape," said SoFi Chief Executive Officer Mike Cagney, who also helps run a hedge fund. "It can affect the industry, but you're talking about a pretty significant backup." (One percent equals 100 basis points.)

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Broadly speaking, alternative lenders are a big reason why venture capitalists have a renewed interest in financial technology in general. Venture investors pumped $1.07 billion into financial services start-ups in 2014, up from $512.1 million in 2013 and $272.7 million in 2012, according to the National Venture Capital Association.

And LendingClub, the biggest of the new class of U.S. online lenders, raised more than $1 billion in an initial public offering and is currently valued at $7.3 billion. Smaller rival Prosper reached $2 billion in loans issued in October, just six months after topping $1 billion.

Investors in LendingClub and Prosper loans commonly see annual returns of 5 percent to 10 percent and even higher.

Targeting young, pre-prime demographic

Other players have jumped into the lending space in recent years to provide small business loans, payday lending, merchant cash advance and real estate. Foundation Capital, a backer of LendingClub and business lender OnDeck Capital, estimates this new group of lenders is vying for a potentially trillion-dollar market by displacing many traditional banks.

For new entry Upstart, founded by former Google executive David Girouard, a key strategy has been targeting a young demographic (average client age 28) that's getting hosed by credit card rates and fees, and putting them into better priced consolidated loans. Girouard describes them as "pre-prime" because data shows they're low risk even without the credit history to be seen as prime borrowers.

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As an example, Upstart chops a 20 percent credit card rate in half for the borrower, still leaving investors with a return after fees and expected defaults of something south of 10 percent.

"On the borrower side, we have 1,000 basis points between the debt they're refinancing and the average loan on Upstart," said Girouard, whose company has issued about $70 million in loans. "We'd be fine if prime rates went up 100 to 200 basis points. It could have an effect, but not anything catastrophic," he said.

Again, Upstart has a monstrous spread even relative to where Fed rates are headed, giving the company plenty of room to raise prices if needed without detracting borrowers.

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The marketplace lending space will continue to remain attractive in part because there are few other lucrative options. Lend Academy's Renton simply asks: Where are fixed income investors going to go?

The 10-year is currently yielding 1.87 percent and the 30-year is at 2.48 percent, not exactly big returns. "Now, it's a very large premium they're getting over the risk-free rate," said Renton, who's based in Denver. "That premium doesn't need to be this large for a lot of people to justify the investment."

SoFi's alternative mortgage
SoFi's alternative mortgage

Building a customer base

SoFi has taken a novel approach to marketplace lending. Early on, the company raised funds from alumni of universities such as Stanford and Harvard, and used that money to refinance loans from graduates of those schools at better rates. The company has since moved into personal loans and mortgages and has a wide, diverse set of investors.

Cagney acknowledges that student debt refinancing is Fed sensitive because the existing loans are based on rates that were set years earlier. But it doesn't matter if those loans become less profitable because getting recent college grads to trust the brand gives SoFi a huge potential customer base.

Longer term, the thinking goes, these young consumers will eventually look to get married, become homeowners and travel the world, mitigating short-term risks.

"If we made no margin on student loans, we'd still do it because of the relationship we're bringing in the door," said SoFi's Cagney.