What happened

Shares of newly public fintech companies Upstart Holdings (UPST -1.97%), SoFi Technology (SOFI -0.28%), and Lemonade (LMND 0.83%) were plunging today, down 5.2%, 9.3%, and 3.1%, respectively, as of 1:25 p.m. ET.

It wasn't a good first half of the trading day for growth stocks in general, as investors may be worried about the Federal Reserve meeting today, in which the Fed is widely expected to raise interest rates by 75 basis points and give commentary on the rate hike outlook into next year.

This year's rapid rate increases have hurt fintech stocks broadly in several different ways. Today, it appears investors are nervous again after the recent one-month rally in growth names. The decline even took hold of SoFi, which handily beat revenue and earnings estimates just yesterday, as the stock gave back all of its post-earnings gains, and then some. 

So what

Rapidly rising interest rates hurt fintech stocks in a number of ways. First, since so few of them are profitable -- these three included -- fintech stocks are discounted to a great degree in a rising-rate environment, purely due to the fact that they have the bulk of potential earnings far out into the future. The higher long-term rates are, the less those future earnings are worth. This goes for virtually all unprofitable growth tech stocks, most of which are also down today.

Secondly, fintech stocks typically have more precarious funding than big banks. While large, national banks can get away with paying very low interest rates on their deposits, fintech stocks generally don't have that luxury. That means fintechs may have to endure lower margins or take undue credit risk to make up for funding costs. 

For instance, Upstart's business model is to be a platform for artificial intelligence (AI)-powered loans, which it then sells to third-party loan buyers. However, in a rapidly rising rate environment, the threshold for returns goes up rapidly, and many loan buyers are stepping to the sidelines until rates settle out. That's why Upstart's growth has slowed, and also why the company had to resort to holding loans on its balance sheet earlier this year, in violation of its business model. In recent days, Upstart fired 140 people in order to cut costs, as demand for loans dried up.

Even SoFi, which received a banking license earlier this year and can therefore accept its own deposits, has raised the annual percentage yield (APY) on its checking accounts rapidly this year. Just last week, the company raised the APY to 3% on its savings accounts in order to attract more depositors. That's much higher than large money-center banks will have to pay. While SoFi reported impressive revenue growth and customer acquisitions last quarter, it's still unprofitable. That could be why the stock is down following its initial spike up after its well-received earnings report on Tuesday.

Meanwhile, since each company is relatively new to public markets, some may wonder how profitably they will really underwrite their customers in a downturn. None of these companies has experienced a bad recession, so investors may be seeing them as risky. Will Upstart's AI models really generate sufficient returns if charge-offs rise? Can Lemonade underwrite insurance profitably?

So far, Lemonade hasn't been able to control its costs amid inflation this year, with gross losses a bit higher than projected. CEO Daniel Schreiber said in his second-quarter shareholder letter that the company's losses should peak in the third quarter and improve thereafter, but investors are still clearly nervous, with the stock down 67% over the past year.

Now what

The performance of fintech stocks will likely be dictated by the path of the Fed and interest rates over the near term; however, with these stocks having been absolutely decimated this year, they could have material upside if inflation cools and interest rates pause or decline.

Yet that probably won't happen anytime soon, as inflation has proved relatively resilient even through October. Interested investors should take the time to investigate these companies' business models, end customers, and risk controls. Are they built to withstand a recession? Are these tech-forward companies really disrupting a certain corner of finance, or are they just beneficiaries of the prior era of low interest rates?

If one can get comfortable that these companies' business models are the real deal and that their balance sheets are able to withstand a recession, these stocks are likely to be a long-term bargains. However, if the business model has a vulnerability in it, a recession could mean further losses, or even bankruptcy. Fintechs remain high-risk, high-upside bets at the current moment of great uncertainty.