The incredibly hot buy now, pay later market is not expected to cool anytime soon. The media raves about BNPL. Venture capitalists are searching for the next Affirm and AfterPay. Financial institutions are enabling BNPL features, as part of their credit card offerings, and payment networks are jumping on board.
But there is a dark side to BNPL that is rarely mentioned. Not in the sense of some malevolent intent on the part of companies involved with the product — BNPL offers benefits to consumers, after all, as well as merchants and providers. But BNPL as currently offered is saddled with several negative realities that each need to be carefully considered.
There are many variations of buy now, pay later services, but the main ones allow consumers to select a BNPL service (such as PayPal, Klarna, Affirm and Sezzle) at the point of sale to spread out the purchase price interest-free typically in four, but sometimes more installments.
In analyzing the various BNPL options based on my experience running, building and scaling BNPL and POS lending businesses [the author was formerly EVP and General Manager at LendingPoint, and Head of FinTech, U.S., at KPMG], five potential trouble spots emerged.
Reality 1. BNPL Players Have a Profitability Challenge
Lenders don’t make money on interest free loans. Compared with traditional installment loans, BNPL transactions typically make less money for lenders with the business model in place today.
The primary revenue streams for BNPL loans include the following:
- Merchant discount rate (MDR), i.e. fee merchants pay to BNPL firms.
- Interchange fees, if a credit card is used as part of the transaction.
- Flat per-transaction fee (in some cases).
- Late fees (in some cases).
- Interest, if BNPL loan defaults to a traditional installment loan. (Lenders term this a “busted loan, and the frequency with which it occurs as the “bust rate.”)
The key issue with BNPL is that total profit made from MDRs that range from 2% to 8% and bust rates of 25% to 35% — combined with any other fees — does not equal the money made from a traditional installment loan for the same loan amount. The two scenarios below illustrate the difference:
Scenario 1: Traditional installment loan
Term: 36 months
Interest rate: 19.99%
(Assumes zero cost of capital, zero late fees, etc., for simplicity.)
Net interest (profit) = $430
Scenario 2: BNPL loan
Term: Pay in four interest-free (or 36 months installment loan if “busted”)
Interest rate: 19.99%
Bust rate: 30%
(Assumes zero cost of capital, zero late fees, etc., for simplicity)
Net interest (profit) = $204
For the same loan amount, lenders make less than half the profit with BNPL compared with a traditional installment loan.
To compensate for the lower revenue, BNPL players will either need to increase the merchant discount rate (which might not be compelling given the costs to merchants, discussed next), or come up with other ways to boost revenue. In the above example, the MDR for BNPL loan would need to be about 20% to make a net profit of $430.
This is one reason BNPL players are rushing to offer other traditional financial services products on top of BNPL for additional revenues and to build a profitable platform.
Reality 2: BNPL Is Expensive for Merchants
As mentioned, merchants that accept BNPL have to pay between 2% and 8% in fees plus interchange costs; plus in some cases a flat per-transaction fee — typically 15 to 30 cents. There are also administrative costs paid to BNPL firms for billing, servicing and collections.
In addition, there is little in the way of guidance when it comes to merchant education about BNPL programs. For example, how to ethically promote these types of plans and make all the different fees and interest rates transparent to consumers.
Reality 3. Buy Now, Pay Later Can Confuse Consumers
BNPL loans are handled by a separate company and not the merchant. So when an item is canceled and a refund is needed customers get confused who to reach out to — is it the merchant or the BNPL firm?
While some merchants may assist with this, others may not. Consumers are left having to manage the refund and/or credit process directly with the BNPL provider. The experience can be frustrating and can outweigh the slick experience offered at checkout.
Reality 4. BNPL Creates Spending Behavior Possibly Worse Than that of Credit Cards
Borrowing money always comes with consequences. In the case of BNPL, seamless checkout makes it easier for customers to impulse buy and overspend. If customers struggle to spend too much on credit cards, BNPL could tempt them to rack up even more debt outside of their credit card limits. One of the things merchants like about BNPL, despite the cost, is that it leads to larger purchase amounts.
One in five consumers believes that BNPL services take advantage of them by creating more financial hardship, according to a survey by The Strawhecker Group.
Reality 5. An Uncertain Regulatory Landscape
Millennials and Gen Zers, in particular — a prime target market for BNPL — are at a stage in their lives where they need to learn to build responsible financial habits. Products like BNPL do not help, as it makes impulse buying easier creating a habitual activity to spend without the financial means. When it comes to financial health, sometimes waiting to save first is worth it.
Compared to the heavily regulated credit card industry, BNPL providers have operated with relatively limited oversight. This is a risk to BNPL firms, especially as regulatory scrutiny has been on the rise. Some examples:
AfterPay (now part of Square) paid a roughly $1 million settlement with California’s Department of Business Oversight, which found that the company structured products to “evade otherwise applicable consumer protections” and made loans to California residents without a valid license.
In late 2020, Klarna was reprimanded by the U.K.’s advertising regulator for commissioning influencer social media posts to encourage spending to improve “moods.”
Sweden (where BNPL leader Klarna was launched) has enacted a law ensuring that BNPL options can’t be offered as the ‘first choice’ at checkout.
Some also argue that potential BNPL regulations will require merchants to become authorized for credit brokering, which may discourage smaller merchants from offering the service given the additional hassle and risk.
The Complex U.S. Regulatory Landscape
Regulating BNPL in the U.S. is more complex because laws vary by state. However, the Consumer Financial Protection Bureau issued a statement warning consumers of the risks of BNPL credit. In addition to cautioning consumers not to overextend their finances, CFPB advised consumers to do their own research before signing up for BNPL credit.
The agency warned that even though many BNPL firms do not charge interest, some charge late fees and/or overdraft fees; some report late payments to credit agencies harming consumer’s credit, and some send unpaid debt to a debt collector for collections.
Indeed, according to a study by Credit Karma, 40% of US consumers who used BNPL missed more than one payment, and 72% of those saw their credit score decline.
As a result of increased supervision, merchants and BNPL firms might need to adjust fees and business models – or even the BNPL product itself.
Why It’s Not All Doom and Gloom for BNPL
Despite the above cautions BNPL is likely here to stay because it is a great credit tool offering benefits to both consumers and merchants. Here are some of the key ones:
- It’s convenient, transparent and low-cost compared to credit cards which come with hidden fees, compounding interest, and various penalties.
- When used responsibly, BNPL helps consumers with managing budgets.
- The product helps merchants increase average order value by 20% by 35% and cart conversion by 20% to 85%.
- BNPL is deeply integrated into the shopping and buying journey.
On balance, every financial product comes with a mix of merits and demerits – BNPL is no different. Consumers need to be educated about it so they understand that most BNPL products come with late fees for non-payment and high interest rates if the initial loan is defaulted and moves to an interest-bearing loan.
Likewise merchants should also educate themselves about the product and find business arrangements to share costs and revenue with BNPL firms.