As we head into the holiday shopping season, one new service is looking to ease shoppers' concerns: Buy Now, Pay Later (BNPL). Some estimates show that more than half of Americans are interested in using the service this holiday season, citing 69% of a survey population using the service to help with budgeting.

While financing options have been available in the past (e.g. layaway) consumers and retailers are embracing Buy Now, Pay Later as a new option for shopping, begging the question: how do Buy Now, Pay Later programs work? Why have they been able to gain popularity in recent months? What are the risks associated with this program? And lastly, what does this mean for me as a consumer and investor?

Sources:
Barrons, October 2021. “Affirm Stock Soared on Target Partnership. It's Not the Good News the Market Thinks It Is.”
Economic Times, August 2021. “Buy Now Pay Later is the flavour of festive season for top Internet firms.”

Buy Now, Pay Later financing companies generally provide consumers the option to split a purchase with interest-free financing for a certain time period while allowing the consumer to receive the product now, as opposed to layaway which provides the product after all payments are made. Payments are designed to align with paycheck cycles, usually paid every two weeks.

Late fees will likely be assessed if a consumer misses a payment. BNPL companies also charge merchant fees which are paid by the retailer and range from 3-5% per transaction.

Sources:
Klarna. “Buy now pay later – How it works | Klarna US”
Afterpay. “How it Works – Afterpay.”
Affirm. “How it works | Learn how to pay over time with Affirm.”
Medium, May 2020. “How Buy Now, Pay Later is changing the face of retail.”

Easier Credit Standards

The Buy Now, Pay Later providers don't have the same underwriting standards as banks and often approve applications in a fraction of the time compared to credit cards. For consumers who lack access to credit or do not wish to use a credit card, the BNPL program provides an option for them to split larger purchases without having to undergo the same thorough credit check as with traditional lenders. Ally Lending President Hans Zandhuis notes that BNPL provides a viable option for customers that don't have the necessary funds now for the total purchase but will over the next pay cycles.

According to Hemal Nagarsheth, an associate partner in Kearney's financial services practice, installment payments give consumers more alternatives and ease when it comes to budgeting and purchasing. Nagarsheth notes the choice builds confidence between shops and customers, resulting in "incremental purchases, greater average buy volumes, and higher purchase frequency."

Affirm reports its retailer clients experience an 85% increase in average order value when customers choose to use its BNPL compared to other payment methods.

Higher Conversion Rates

Merchants pay the Buy Now, Pay Later providers a fee to offer the interest-free payment plan and capture potential higher ticket sizes. According to RBC Capital Markets, these payment options enhance retail conversion rates by 20 to 30 percent and raise average ticket size by 30 to 50 percent.

The installment programs enable retailers to "convert" a consumer's wish into a purchase, as noted by Chris Ventry, Vice President at global consultant group SSA & Co. According to Ventry, "it eliminates the ability-to-pay roadblock. For those using debit cards, the potential for an extended interest-free payment schedule through BNPL is enticing, ultimately enticing enough to drive conversion, which is the primary goal of all digital commerce sites."

New Customers

Another reason why other companies are embracing the BNPL program is that it can be used to attract new customers to stores. Macy's CEO, Jeff Gennette, in discussing the store’s recent BNLP efforts said, “we continue to see higher spending per visit and increased acquisition of new younger customers, 45% are under 40. Our goal is to convert all of these new customers to Macy's loyal customers, who return for future purchases."

In a review led by Chris Woolard, roughly 75% of Buy Now, Pay Later users were under the age of 36, illustrated in the demographics breakdown below.

Sources:
CNBC, September 2021. “ Retailers bid farewell to layaway, as shoppers embrace Buy Now, Pay Later options.”
BBC, October 2021.” Klarna to offer pay now option ahead of crackdown.”

Limited Avenues for Growing Customer Acquisition

Redburn reports that these Buy Now, Pay Later players have been successful in customer acquisition, but fall short of other tech players, which use customer acquisition to sell other products to new customers. Companies such as PayPal and Square that have other services within their business model can leverage the accelerating customer acquisition of BNPL to introduce bundled payment pricing on their products.

Square entered the BNPL space with its acquisition of Afterpay in a $29B all-stock deal. The transaction is anticipated to close in Q1 2022. Jack Dorsey, co-founder and CEO of Square, stated the two fintech firms "have a shared purpose."

"We built our business to make the financial system more fair, accessible, and inclusive, and Afterpay has built a trusted brand aligned with those principles," he said in the statement. "Together, we can better connect our Cash App and Seller ecosystems to deliver even more compelling products and services for merchants and consumers, putting the power back in their hands."

Source: TechCrunch, August 2021. “ Square to buy 'Buy Now, Pay Later ' giant Afterpay in $29B deal.”

Potential for Regulation and Shrinking Margins

One of the reasons for the accelerated growth of BNPL is the limited regulation of the sector, which may change if the credit cycle turns. If BNPL experiences a credit event, not only will losses accrue, but also tighter regulation will likely follow. The potential for adding credit checks as required by banks when issuing loans could be added to the BNPL sector, which would slow new customer adoption from the current minimal credit checks.

Increasing regulations would likely lead to higher costs for BNPL companies and squeeze the slim profit margins.

Below is a chart illustrating a typical pricing structure, assuming the retailer pays 4 percent to the BNPL vendor:

Sources:
Financial Times, October 2021. “ Is "buy now pay later" a viable business model?”
BBC, October 2021. “ Klarna to offer pay now option ahead of crackdown.”

Growing Consumer Debt

Fitch Rating found the Buy Now, Pay Later debt performance reporting as "opaque" since these providers do not report the use of their financing programs to the credit bureaus. Analysts report the lack of credit checks and "opaque" debt reporting may cause lenders to underestimate debt levels and consumers to unknowingly rack up unsustainable debt levels in the process.

As part of a study conducted by the Australian Securities and Investment Commission in November 2020, the team surveyed Buy Now, Pay Later users and found that in the last 12 months, about 15% of consumers need to take out a second loan to make payments on time and of that 15% population, roughly 50% were between 18-29 years old. Additionally, Fitch finds that the debt from BNPL could result in higher credit card debt if consumers are unable to make payments. Fitch cited a major UK bank as saying that 10% of its over 660,000 customers who paid their BNPL plan had exceeded their overdraft limit for that month. Within the US, the Federal Reserve found household debt reaching its highest level in 14 years during the second quarter of 2021 with credit card balances increasing by $17 billion compared to the first quarter, totaling $787 billion.

Sources:
CNBC, October 2021. “The ‘buy now, pay later’ trend could be the next hidden source of consumer debt, analysts warn.”
Australian Securities and Investments Commission, November 2020. “ Buy now pay later: An industry update.”

Threat of Rising Defaults

According to a new survey published by personal finance company Credit Karma, a third of U.S. consumers who used "Buy Now, Pay Later " services have fallen behind on one or more payments, and 72 percent of those have seen their credit score drop. The survey reported that younger consumers are more prone to miss payments. More than half of Gen Z and Millennial (those born between the early 1980s and the mid-to-late 1990s) respondents stated they have missed at least one payment, while comparatively, Gen Xers (those born between the early 1960s and the early 1980s) made up 22% and Baby Boomers (those born between the mid-1940s and 1980) comprising 10%.

Colleen McCreary, a financial advocate at Credit Karma, notes, "it's easier than ever to buy something — and finance it — without ever considering the consequences. It's this disconnect between making a purchase and actually paying for it where consumers can get in trouble."

Source: Reuters, September 2021. “ As 'buy now, pay later' surges, a third of U.S. users fall behind on payments.”

While concerns for the Buy Now, Pay Later practice are necessary to consider, BNPL is likely to stay as an option for consumers and is expected to grow into other developing markets.

According to FIS WorldPay, Buy Now, Pay Later currently accounts for less than 2% of North American sales, with the potential to expand at a compound annual growth rate of 28% by 2023, reaching $166 billion and representing around 5% of global e-commerce, outside of China.

Source: CNBC, September 2021. “Retailers bid farewell to layaway, as shoppers embrace Buy Now, Pay Later options.”

After witnessing the success of BNPL services in developed credit markets, venture capital firms are picking up investments in Buy Now, Pay Later providers, particularly in under-developed markets, where the growth opportunity is expected to remain high. Companies are looking to provide the installment payments program to under-developed credit markets. Buy Now, Pay Later services are now looking to expand throughout Mexico and Latin America.

Source: TechCrunch, October 2021. “Nelo joins the BNPL rush, with $20M in new funding and the Mexican market in its sights.”

BNPL providers have shaken up retailer business models and consumer psychology behind purchases. However, the opportunities provided to both retailers and consumers through these flexible payment plans bear mentioning the likely outcome of future regulation to help protect both amidst a credit downturn. Growth remains in what seems an already saturated market, as companies look to expand these installment payment offerings to underserved markets.