The Real Risks and Hidden Costs in the Buy Now Pay Later Game

Fitch Ratings examines the economics of buy now, pay later programs and sizes up the potential for BNPL replacing cards. While these programs have not made nearly as big a dent in cards' market share as some thought, that could change fast. However, credit performance issues and regulation could affect the outcome.

Buy now, pay later programs offered by fintechs and a gradually increasing number of banks are one of the hottest consumer financial products on the market right now. Hot as they are, what is the long-term potential of this merchant-based credit model? And should more traditional financial institutions push into this market while opportunity remains and before it becomes a commodity?

In a special report Fitch Ratings examines the economic pros and cons of BNPL, giving a deeper look at the business details of this form of lending than is typically the case. The report points out that Fitch does not rate any BNPL platforms at present, but used its ratings methods to see how viable expansion into BNPL would be for the lenders it rates.

The report compares its examination of the BNPL model to the traditional credit card model and suggests that in time the outlook for “pay in four” and other variations could affect the firm’s ratings of financial institutions that offer credit cards, especially “monolines” — companies that specialize in issuing cards.

What It Means:

Fitch states that BNPL’s growth could in time lead the credit agency to downgrade traditional card issuers.

One of the biggest question marks is how U.S. financial regulators will oversee BNPL, because the costs and strictures of compliance can have a significant impact on the viability of credit products. Traditional players are already in the regulatory net, but the newcomers are not. “BNPL providers in the U.S., such as Affirm, leveraged bank partnerships rather than becoming banks themselves, and are therefore not subject to regulatory oversight,” Fitch observes. Could this change?

“The industry attracted greater regulatory attention, with the Consumer Financial Protection Bureau reviewing disclosures around late fees and overindebtedness, and may come under greater scrutiny following the recent confirmation of Rohit Chopra to lead the agency.”

— Fitch Ratings report on BNPL trend

Looking at BNPL By the Numbers

As Fitch points out, a major plus for BNPL is that a growing number of consumers want it, especially Millennials and Gen Z who love the no-interest feature of most BNPL plans. And it has lots of room to grow, especially in sales at physical stores, where Fitch says 80% of retail sales still take place. BNPL has taken off for ecommerce especially. Some websites are now offering purchasers options from multiple BNPL companies.

Currently, credit cards have advantages over BNPL, such as wide merchant acceptance. Consumers can bring any major credit card to nearly all merchants that accept them, whereas you can only tap BNPL at sellers who offer the service.

Other pluses for cards include fraud protection and popular rewards programs. And while credit card interest is expensive, the option to pay in full or roll over and pay over time offers flexibility that installment plans don’t.

“Longer term, Fitch believes growing consumer adoption and merchant acceptance of BNPL could be a disruptor of the credit card issuer business model.”

— Fitch Ratings

In time, the report says, Fitch might have to downgrade traditional card issuers because of the competitive impact.

For traditional players entering the business, the report explains that there are four sources of revenue in merchant-based BNPL, as opposed to credit card programs that offer options for paying in installments:

  • Discount rates that merchants pay the BNPL provider to use the program, in order to boost sales through interest-free installment plans.
  • Interest paid by consumers on longer-term installment plans, and late fees and interest when they miss payments on subsidized programs.
  • Advertising revenues from merchants who pay BNPL vendors for promotional visibility on their websites and in their apps.
  • Fees for setting up “white label” BNPL programs for merchants who want to maintain their own branding.

A sampling of the business case: “Assuming BNPL platforms are able to extract a 4% merchant discount rate on 6-8 week installment loans and the consumer users the BNPL platform five or six times over the course of a year, it would translate into a credit card-like annual percentage rate (APR) in the low-20% range.”

Fitch points out that consumers like the idea of “compartmentalizing” purchases, using credit cards for larger, longer-term purchases and BNPL for smaller purchases. Part of the appeal is the lack of interest on the latter, though Fitch points out that “at least some portion of the indirect cost of BNPL borne by merchants is likely to be passed back to consumers through higher prices for goods and services.”

The issue of the discount rates merchants pay to accept credit cards has been contentious for years. However, Fitch says that even though BNPL generally costs more for merchants to offer, they tend to see the programs as driving sales more so than credit cards do.

In time, merchants who offer private-label retail cards may have to weigh the prospect of increased sales against the risk of losing revenue they gain through private-label cards, according to Fitch. If they decide to drop the cards, their banking partners would lose that revenue unless they could grab the BNPL connection.

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BNPL Seen Through the Lens of Credit Risk

While merchant-based installment programs were on the market before the pandemic, Fitch says it is hard to evaluate the quality of BNPL credits because of overlaying economic factors. These include the distortions caused by the pandemic as well as the overall improvement in consumers’ balance sheets.

Fitch is inclined to be skeptical, citing “a more cautious view of unsecured personal installment loan asset quality due to weaker performance relative to other consumer loans through prior credit cycles.”

One reason is that BNPL purchases are typically underwritten every time a consumer buys something that way. Failing to pay as agreed will cut off a consumer from further business with that BNPL platform but that is not the same as losing all use of a credit card. Fitch indicates that this may lead consumers to prioritize card account payments if they get into some difficulty.

“BNPL providers also enable customers to link their monthly payments to their credit cards, which could lead to a layering of debt and an overleveraging of consumers,” Fitch warns.

Already, Fitch recounts, a Credit Karma survey has indicated that about a third of BNPL users have missed one or more payments.

The Dark Side of Increased Sales:

BNPL providers promote these programs as sales boosters. But while consumers may not pay interest, they still have to pay the installments. Fitch worries about impulse buying “that would otherwise be unaffordable.”

Research cited by Fitch indicates that many BNPL users are not prime customers. Near-prime and subprime borrowers tend to use the programs, it says. This, and use by other “thin-file” borrowers — those with little or no credit history — makes credit risk a greater factor for BNPL providers.

So, Should Your Institution Jump into BNPL?

Each institution has to judge this opportunity based on its own circumstances. While Fitch has sketched out revenue opportunities, it has also pointed to credit risks which would erode revenues.

Such decisions don’t take place in a vacuum. When First National Bank of Omaha decided to venture into BNPL, part of the reason was that specialist companies were calling on the bank’s credit card merchants. The merchants began asking First Omaha what BNPL options it could offer them.

Fitch points out that many BNPL loans are technically retail installment sales contracts, which exist in a legal loophole that avoids some rules that apply to credit. However, loopholes do get closed, which could bring more compliance costs to BNPL platforms. And BNPL companies have been looking at expanding into traditional banking products, which may bring compliance duties depending on how they are structured.

But making the BNPL move is clearly something traditional institutions must consider. Concludes Michael Taiano, Senior Director at Fitch: “Failure to adapt and compete effectively with these new payment/commerce constructs could result in the loss of market share and reduced profitability that could lead to negative rating momentum, particularly for monoline card issuers.”

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