State of “Buy Now, Pay Later”

07.08.22

Food journalist Kitty Drake has a complicated relationship with PayPal. Ever since opening her PayPal credit account last year — an interest free loan installment plan (for the first six months) — she finds herself making secret purchases in the dead of night.

“My purchases are small and mad, but they are also aspirational: a miniature gong; a leopard-print hat; a candle that says ‘ciao’ on it,” writes Drake. “I only move one thumb when I shop, but in my head I am whizzing through time and space. I am the woman wearing the leopard-print hat and lighting the candle. I am now in several hundred pounds’ worth of debt.”

Drake is just one of many who was drawn in by the easy comfort of “Buy Now, Pay Later” (BNPL) options. Now ubiquitous at the bottom of online shopping checkouts, BNPL companies funded approximately $97 billion in consumer transactions in 2021, up from $24 billion in 2020, a 404% increase. Projections show BNPL’s reach expanding to 10% of all e-commerce dollar volume by 2024.

BNPL’s widespread popularity and exponential growth prospects have attracted the scorn of journalists, parents, banks, and, increasingly, regulators. In December 2021, the Consumer Financial Protection Bureau (CFPB) opened an inquiry against five BNPL providers — Affirm, Klarna, Afterpay, PayPal, and Zip — citing concerns of accumulating debt, regulatory arbitrage, and data harvesting.

“However they are styled, products that provide funding or cash today and that are repaid later are credit,” testified Lauren Saunders of the National Consumer Law Center to the U.S. House Committee on Financial Services. “Shiny fintech garb does not remove the need for basic consumer protections to ensure that credit is affordable, responsible, transparent, and fair.”

Yet, some are aghast at the moral panic and believe it obscures the many positive benefits that BNPL provides consumers. “They expect young people to save up their pocket money in a little porcelain piggy bank and wait until they’ve got enough pennies like good little boys and girls,” wrote one commentator, who sees BNPL critics as reactionary, classist, and sexist.

“In contrast, you have the credit card industrial complex… where cards are framed as the sober sensible choice of adults for big important purchases like golf clubs, a new lawnmower, or that pair of leather driving gloves. My dad might use it to collect points for airport lounges, but his credit card quite literally offers a worse experience by almost every metric. So, who are the real victims here, the Gen Z BNPL users or the credit card boomers?”

This week, we discuss the state of BNPL lending: its unique credit risks, its irresistible value proposition, and its transformation of the traditional credit-merchant-consumer relationship.

How BNPL Trumped Credit Cards

While most focus on the real or imagined risks of BNPL to consumers, the technology is fundamentally an acquisition channel for merchants. Merchants subsidize interest-free, short-term installment loans in exchange for more customer bites. BNPL — by providing more affordable financing than traditional credit cards (in most product offerings) — brings in customers who might otherwise have abandoned the cart or waited for the next sale.

In 2021, Afterpay boasted that it drove $8.2 billion in new sales revenue for participating merchants (an 11% increase in profit margin); it claimed that Afterpay merchants attracted 13% more new customers; and that ‘basket sizes [i.e., shopping carts] are 17% higher in value’ than before Afterpay.”

Besides drawing in more customers, BNPL also offers merchants distinct advantages over competing credit card providers. Its holy grail is data: whereas traditional credit card providers are blind to what its users are actually buying, BNPL providers are privy to barcode-level data, opening up a treasure trove of possibilities. Alex Rampell, General Partner at Andreessen Horowitz and co-founder of Affirm, believes BNPL’s ability to upend traditional credit card transactions makes it “an early threat to trillions of dollars of market cap.”

Rampell critiques traditional credit card transactions for involving a cumbersome number of parties — consumer, issuing bank, network, acquiring bank, and merchant — while sustaining superficial relationships across the transaction chain. “Visa doesn’t even know who you are,” says Rampell. “Visa doesn’t work with you as a consumer. You never have a relationship with Visa, nor does Chipotle have a relationship with Visa.”

BNPL, on the other hand, knows exactly who you are. “This is what makes BNPL so interesting,” tweets Rampell. “It’s a **parallel** network, with SKU level information, that bypasses the issuing bank, card network, and merchant acquirer. It’s just the consumer, the merchant, AND (this is exciting!) a new participant: the product manufacturer!” He adds: “Right now, this parallel network is being used for installments / customized financing — the clear product-market need and the hole the ‘one-size-fits-all because of no SKU-data and five parties’ created. But adding SKU-level info and manufacturers is a HUGE unlock for more.”

What might “more” look like? Product-specific coupons, customized warranties, personalized financing options, etc. Rampell’s company, Affirm (also co-founded by Max Levchin, better known for co-founding PayPal), has already started trialing such possibilities with Adaptive Checkout. “You can think of it as a router for financial tools,” said Levchin in a recent earnings call. “It’s this canvas where you say, hey, here’s three choices: this one has no interest at all, this one is a little bit longer term, but has some interest, etc.”

Whereas credit card companies once hoped to draw in lifelong customers through their first checking accounts, BNPL providers now hope to draw in lifelong customers through their first experience with embedded lending. The ultimate goal, admits Levchin, is to create a user interface so seamless and so convenient that, “once you’re using the app, you’re basically starting to think of Affirm as a replacement for your ‘purchasing device.’”

The Risks of BNPL

One of the first companies to be accused of being a “modern-day loan shark, but with better branding,” was Klarna, the Swedish BNPL giant known for serving 85 million customers and “bankrolling wardrobes around the world.” Co-founder Sebastian Siemiatkowski — whose Twitter tagline aspires “to be the nightmare of the bank establishment worldwide!” — admits that his company exists in an industry that “unfortunately has historically ruined people’s lives.”

Yet, he insists that Klarna is different. “We care a lot about responsibility,” says Siemiatkowski. “Banking has never been customer-friendly, and I think we can be a beam of light in that industry to change and improve it.” In 2014, however, the Swedish Consumer Agency received a large number of complaints about receiving reminder fees and threats about debt collection with receiving an official invoice. Customers speculated that Klarna had a vested interest in not informing them since the company made money off reminder fees and had its own debt collection subsidiary.

Regulations and consumer expectations have evolved over time. For years, most pay-in-four BNPL providers (as opposed to longer-term BNPL lenders) operated without hard credit checks and did not report transactions to credit bureaus unless the payment wound up in collections. The Truth in Lending Act failed to cover creditors who didn’t require a finance charge or allowed four or fewer installments.

“Without credit reporting, the borrower’s BNPL debts across lenders are not aggregated anywhere and, even with credit checking, lenders (BNPL or other lenders) have no lens into how much BNPL debt borrowers are carrying,” testified Marisabel Torres of the California Policy Center for Responsible Lending to the U.S. House Committee on Financial Services. This quickly became a problem for repeat users, of which there are many (one survey found that Quadpay and Sezzle borrowers average four-to-five transactions per month; Afterpay and Klarna borrowers four per month; Affirm borrowers two per month).

Another concern is how BNPL providers will fare in a rising interest rate environment. Some investors worry that BNPL products are untested in a recessionary period and may result in a wave of delinquencies. Levchin, however, who was a member of the CFPB’s consumer advisory board from 2015 to 2018, was unflummoxed. “As a reminder, we do not charge late fees or allow revolving,” Levchin told investors. “In other words, we have a structural incentive to decline a transaction that we believe to be a bad financial decision for you, because approving it is guaranteed to be a bad financial decision for us.”

Levchin cites Affirm’s high scale of transactions (over 10 million in the last quarter) as another tool for fine-tuning risk. “Another key structural advantage is the very short weighted average life of our loans, which is about 5 months. As the economic cycle changes, the loans we made in the past will have a rapidly diminishing impact on Affirm’s future financial performance.” As of May 12th, Affirm’s 30-day-plus delinquency rate on the majority of its active loans (excluding Split Pay loans) hovered between 2% and 3%.

The Future of BNPL

Today, BNPL providers are increasingly reporting transactions to credit bureaus. In late 2021 and early 2022, each of the big three credit bureaus — Experian, Equifax, and Transunion — announced that they would be incorporating BNPL accounts into a consumer’s credit file later in 2022. BNPL providers urged them to account for the frequent opening and closing of accounts — a baked in feature of BNPL — without dragging down credit scores.

The bureaus were quick to take note, adjusting their systems to analyze short-term installment loans. Equifax, after adding Pay in 4 payment plans to their credit reports, found that “people who have limited credit history, thin credit files, [and] no more than two years of credit history… saw an average FICO credit score increase of 21 points.” More typical borrowers saw an average increase of 13 points.

Many see it as a win-win for lenders and consumers alike. “We believe it’s the biggest financial inclusion opportunity we’ve seen in generations,” said Liz Pagel, senior vice president and consumer lending business leader at TransUnion. “There are a lot of credit-building offers out there, and this one is pretty straightforward. If you use this responsibly, you should be able to build credit.”

BNPL providers, for their part, hope their product continues to be “top of wallet” while expanding credit to historically underserved groups. “The number one most visited physical retail used by Debit Plus consumers right now is Walmart groceries,” said Levchin. “That’s probably the warmest, fuzziest news I’ve heard about the product so far. We want it to be top of wallet. We want it to be the thing that people take to go shopping for their family to give them financial flexibility.”

About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.