Upstart Holdings (UPST -3.76%) and Affirm Holdings (AFRM -3.49%) were both once considered disruptive fintech companies. They also had the attention of growth stock aficionados.

Upstart attracted attention because it challenged credit reporting services by analyzing a wide range of non-traditional factors -- including a person's education, GPA, standardized test scores, and work history -- to approve loans for customers with limited credit histories.

Affirm's attention came because it challenged credit card companies with a "buy now, pay later" (BNPL) service which enabled customers to split large purchases into smaller installments. That approach, which approved "microloans" for every purchase, also targeted customers with flawed or limited credit histories who couldn't get approved for traditional credit cards.

A person makes a purchase with a smartphone.

Image source: Getty Images.

Both companies attracted a stampede of bulls during the growth stock rally last year. Upstart's stock closed at a record high of $390 last October, while Affirm's stock skyrocketed to its all-time high of $168.52 the following month. But as of this writing, Upstart and Affirm stocks trade at about $23 and $17 per share, respectively. Let's see why both stocks crashed, and if either one is worth buying as a turnaround play in this tough market for growth stocks.

Upstart gets squeezed by rising interest rates

Upstart features loans on its website, but those loans are primarily funded by its partnered banks, credit unions, and auto dealerships. It charges those partners fees for accessing its platform and servicing its worthy loan applicants.

This business model works well when interest rates are low, because low rates encourage consumers to take out more loans. Lenders also generally have access to more liquidity and face fewer macro headwinds in a low-interest-rate environment, so they're willing to approve more of those loans.

But when interest rates rise sharply, as they did over the past year, this business model is not nearly as appealing. Consumers become reluctant to take out loans at higher rates, while macro headwinds cause lenders to take a more cautious approach to approving loans. That's why Upstart, which had previously tasked its partners with fulfilling all of its loans, finally started temporarily funding some of its loans off its own balance sheet earlier this year.

Upstart's revenue rose 42% in 2020, driven by its 40% growth in bank-originated loans, then surged 264% to $849 million in 2021 as its originated loans soared 338% to 1.3 million. But this year, it expects its revenue to decline 1%-3% as rising rates squeeze its core business. As its growth grinds to a halt, its operating expenses and leverage are climbing as it funds more of its own loans. It ended the third quarter of 2022 with a debt-to-equity ratio of 1.7, compared to a ratio of 1.2 a year earlier. It also posted a net loss of $53 million in the first nine months of 2022, compared to net profit of $76 million a year earlier, and analysts expect it to remain unprofitable through at least 2024.

Affirm gets hit by inflation and subprime concerns

Affirm's BNPL platform might initially seem resistant to inflation because it helps lower-income customers pay for large purchases in smaller installments. However, that business model only works if inflation and other macro headwinds don't cause its delinquency rates to rise.

Only 2.7% of Affirm's accounts were delinquent by more than 30 days at in the first quarter of fiscal 2023 (which ended on Sept. 30), but that percentage could rise sharply if inflation and higher interest rates drive the economy into a full-blown recession. That glaring weakness reinforces the notion that Affirm is essentially a subprime lender which funds smaller purchases, and its elevated debt-to-equity ratio of 1.8 doesn't leave it much room to raise fresh cash.

On the bright side, Affirm is still growing rapidly. Its revenue surged 71% in fiscal 2021, which ended last June, and its total active consumers grew 97% to 7.1 million. Its revenue rose another 55% to $1.3 billion in fiscal 2022, while its active customers increased 96% to 14 million. For fiscal 2023, it expects its revenue to rise 23%-29%.

But Affirm is also deeply unprofitable. Its net loss widened from $441 million in fiscal 2021 to $707 million in fiscal 2022, and analysts expect an even wider loss of $1.01 billion in fiscal 2023. Affirm could potentially raise its merchant fees or interest rates (which are often negotiated on a case-by-case basis) to stabilize those losses, but doing so would narrow its moat against aggressive BNPL competitors like Block's Afterpay and PayPal's Pay in 4.

The valuations and verdict

Upstart and Affirm both trade at about 2 times next year's sales, which suggests their downside potential might be limited. However, neither stock will likely rally until the macro headwinds wane. Therefore, I wouldn't rush to buy either of these out-of-favor fintech stocks in this challenging environment. 

But if I had to pick one over the other, Upstart looks more appealing than Affirm because it had previously generated stable profits in a lower-interest rate environment. Once inflation is reined in and interest rates decline, its prospects could quickly improve and buy it more time to scale up its business. Meanwhile, Affirm hasn't actually proven that its BNPL business model is sustainable yet -- and there's no guarantee that its outlook will improve even if interest rates cool off.