People have been building up sizable credit card balances, and falling interest rates could be a huge boon for this personal lender.

Start (UPST -1.10%) uses artificial intelligence (AI) to evaluate 1,600 variables across 58 million repayment events, making loans accessible to more borrowers and (ideally) achieving lower default rates.

The exciting fintech got off to a red-hot start following its December 2020 IPO, but remains a young, emerging company. Its lending model has a lot to prove as people grapple with decades-high interest rates and near-record levels of credit card debt.

While the company’s long-term potential is enormous, another company with a more mature and stable business model represents a better buy for investors today.

Before you buy Upstart, consider this competitor

The last few years have been difficult for personal lenders, and people have to deal with high interest rates as the Federal Reserve tries to put the brakes on inflation.

The high-interest rate environment has made it difficult for personal lenders like Upstart. They have seen weak demand for their products by both borrowers and investors. Borrowers found interest rates too high for loans, while investors held off on adding loans to their balance sheets as interest rates rose rapidly.

LendingClub (LC -1.62%) is one of the companies affected by the difficult context. Despite its challenges, what makes LendingClub an attractive investment over Upstart is its business model and the fact that the company has multiple levers it can use to generate income in different economic environments.

LendingClub began as a peer-to-peer lending platform in 2006 and struggled in its early years as a publicly traded company. In 2016, the company faced scrutiny of its lending practices and overhauled its management team. In 2021, it acquired Radius Bancorp, giving it a bank charter that gave it more flexibility in its balance sheet.

Owning a bank gave LendingClub a low-cost deposit base, allowing it to hold high-quality loans on its books. This allowed the lender to collect interest income on a portion of its loans (it would hold around 15-25%) while selling the rest of its personal loans to investors in the market.

Before acquiring Radius Bancorp, most of LendingClub’s revenue came from marketplace revenue, where it earned fees for originating, managing and selling its loans. This is quite similar to Upstart’s business model today, which relies primarily on the fintech selling its loans on the marketplace to investors.

LendingClub has decided to retain a portion of its loans to help it generate net interest income. Last year, LendingClub brought in $562 million in net interest income, up 18% from 2022 and 163% from 2021. Net interest income was about 65% of total revenue of the company last year, up from 25% just two years earlier.

Growing net interest margin It was a bright spot for LendingClub, whose shares were hammered along with Upstart and other consumer finance fintechs. Since the start of 2022, LendingClub is down 67%, while Upstart is down 85%. However, LendingClub’s revenue and net income have remained relatively stable thanks to growing net interest margin.

LC Revenue (TTM) data of YCharts

How LendingClub is preparing for a “historic” occasion.

It appears that interest rate trends are finally changing, which should bode well for demand for personal loans. The Federal Reserve last raised interest rates in July last year and has held them stable around 5.3% since then. The central bank has taken a patient approach to inflation, which has gradually eased to 3.4% as measured by the year-on-year change in the headline consumer price index (CPI).

Market participants believe the Fed will cut interest rates next. However, the timing of that cut has been called into question. At the start of the year, traders had predicted up to six interest rate cuts. Those expectations have been pared back to two rate cuts this year.

A drop in interest rates appears to be on the way, which could help make personal loans more attractive to customers looking to refinance as credit card debt tops $1.12 trillion. With credit card interest rates near all-time highs, consumers may be rushing to personal lenders to consolidate debts into a single loan and save significantly on interest payments.

During LendingClub’s first-quarter earnings call, CEO Scott Sanborn told investors, “We have prepared our personal lending franchise to meet the historic future refinancing opportunity.”

To do this, Lending Club is developing products that allow members to roll credit card balances into payment plans. In other words, customers can “top up” an existing personal loan, making it easier to manage their debt balance.

Not only that, but LendingClub is making strides in structuring its loans to make them more attractive to large investors, like asset managers. The company has developed its Structured LendingClub Loan Certificates program, a two-tranche private securitization in which it pools loans into a portfolio and then sells a portion to investors.

Image source: Getty Images.

LendingClub holds the least risky senior security and sells investors a residual certificate on a pool of loans. This helps LendingClub collect a more reliable stream of interest income, while allowing asset managers to earn a leveraged return on such personal loans without the need for financing. The company has sold $3 billion in loans since it launched this structured certification program in the second quarter of last year.

Falling interest rates could be a boon for consumer lenders and create a potentially “historic” refinancing opportunity for personal lenders. While this would benefit both Upstart and LendingClub, I think LendingClub (priced at 11.6x its estimated one-year earnings versus Upstart’s 168x) is a better way to capitalize on this opportunity.

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