Born out of the ashes of the financial panic of 1837, the credit scoring system has come a long way. What started as a subjective pseudo-sleuth on a borrower’s character and assets has grown into a multi-billion dollar industry. This still leaves a lot to be desired.
Reached (NASDAQ: UPST) takes a step into the void and uses artificial intelligence to connect loan application to its network of banking partners. By using artificial intelligence (AI) to more accurately assess risk, the business is able to facilitate higher approval rates, lower interest rates, and a better overall user experience. It’s only just getting started, but the potential is huge.
Artificial intelligence is devouring the world
In 2011, venture capitalist Marc Andreessen wrote an op-ed titled “Why Software Eats the World”. His argument was that the economy was undergoing a radical change where technology – especially software – became the force behind many traditional businesses. Looking around today, you could make the same point for AI.
Upstart’s AI model is built with 10.5 million historical redemption events and relies on over 1,000 variables. While traditional financial institutions may have more transaction data, they don’t have as many variables to use as inputs. These factors help Upstart determine the likelihood that a borrower will repay, the regularity of payments, and even whether they will repay sooner.
The company provides all of this through a simple cloud-based app as a bank-branded lending portal. It can be a website or a mobile. It also allows lenders to tailor their decisions based on their risk tolerance and specific needs such as loan term, yield points and the borrower’s personal financial ratios. It’s a much more personalized approach than what is generally used today. In fact, traditional credit scores are pretty simplistic algorithms that often underapprove and overstate credit.
A better process produces better results
One of the benefits of using the Upstart app is the user experience. With an AI-based model contained in a single website or mobile app, much of the waste is eliminated. Last year, about 70% of loans processed were processed instantly, without requiring phone calls or downloading documents. This was not happening at all as recently as it was at the end of 2016.
The most important measures of success relate to loans. Using Consumer Financial Protection Bureau criteria, the company showed it approves 27% more borrowers than traditional high-quality lending models with 16% lower interest rates. Much like the automated decision-making process, you expect these results to improve over time. They say they have. The company has done this by iterating its predictive model with more robust techniques and as more data becomes available. They have been working there for eight years. It’s a good head start if others try to copy the approach.
A strategy that adapts
Since Upstart derives its income from fees, it has adapted effectively to the volume of loans. This means that the more loans are given, the more income is generated and costs do not increase as quickly. In 2020, the company finally made an operating profit. Financial data shows it was only a matter of time. For the first quarter of 2021, the trend continued. Upstart increased its revenue by 90% year over year with an operating margin of 13%, its highest level to date. For the year, management has guided revenue growth of 158%.
|Year||Returned||Increase in income||Operating result||Operating margin|
|2020||$ 233.4 million||42%||$ 11.8 million||5%|
|2019||$ 164.2 million||65%||(4.6) million dollars||(3%)|
|2018||$ 99.3 million||73%||($ 8.0) million||(8%)|
|2017||$ 57.3 million||N / A||(7.5) million dollars||(13%)|
So far, the company’s app has been used to appraise relatively small personal loans. Its clients are regional banks and credit unions competing with large financial institutions. It is natural to expand the types of loans supported. CEO Dave Girouard has indicated that the auto loan is the next big opportunity. To this end, the company completed an acquisition of Prodigy in the first quarter. Girouard describes it as Shopify for car dealers – a complete e-commerce solution to bring them online. It will immediately increase the number of dealers with the Upstart app by 45%.
If AI eats the world like software did, it will eat it one bite at a time. For Upstart, it started with personal loans and is heading into the $ 1.4 trillion auto loan market. With a business growing rapidly and already generating profits, it’s tempting to imagine how much an investment could grow. As with any new public company, I will take a small position at first. But as soon as the rules allow, Upstart will be the next stock I buy.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.