November 2021

Buy Now, Default Later? A Deep Dive into BNPL

As online marketplaces continue to thrive, a recent digital spin on layaway is gaining serious momentum in e-commerce markets across the globe. “Buy Now, Pay Later,” or BNPL, allows consumers to make purchases in installments with little to no interest, and new competitors in the space are coming out of the woodwork.

Companies like QuadPay, Klarna, Affirm, and even PayPal have begun offering BNPL options for everything from small purchases under $100, to higher ticket items such as home furnishings and exercise equipment. Divido, another popular platform, reportedly just raised a $30 million Series B funding round, and continues to expand international operations.

So what exactly is BNPL, and what’s with all the hype? Is it actually revolutionary, or is it just another payment fad that will die out soon? Let’s take a look at this emerging trend, where it’s going, and how it might impact consumer behavior and e-commerce markets in the long-term.

What is BNPL?

At its core, BNPL is digital layaway. Although different providers take slightly different approaches, the basic idea is this: customers can pay for items at various price points in a series of installments (four is a popular number in the space), and can receive the products as immediately as if they were purchased with a one-time payment. With BNPL, consumers rarely pay more than simple interest, if any interest at all, making the option popular among those who want extra time to pay for products but have reservations about, or don’t have access to, traditional credit.

The recent surge in BNPL’s popularity could initially be traced to Europe and Australia, and now, U.S. consumers and merchants are joining in on the craze. According to 2020’s FIS Global statistics from MarketWatch, BNPL purchases accounted for 7% of European e-commerce sales, 10% in Australia, and around 2% in the U.S. And while Americans have been slow to the BNPL table, a significant boost in the value of installment transactions in the first quarter of 2021 seems to reflect a growing acceptance and enthusiasm for these services in U.S. markets.

Popular exercise equipment manufacturer, Peloton, embraced the BNPL model in 2020, and have been selling their products in interest-free installments via Affirm Holdings Inc., a U.S. provider that went public earlier this year. In this case, BNPL allows you to pay off the lavish, near $2,000 smart bike for a cool $49 per month over three or so years. Some bigger names in finance such as Visa and PayPal are now staking their BNPL claims in the U.S. markets, with the latter’s Pay-In-4 model postured to drive the installment trend toward more modest or everyday purchases.

The BNPL promise has so far held true, or at the very least its impact on consumer behavior is impossible to deny. As Forbes reported in a recent article, consumers are expected to spend $100 billion in retail purchases through BNPL providers in 2021, a considerable uptick from the $24 billion spent in 2020. And while these numbers seem to be a positive indicator of the concept’s integrity and of its future in fintech and e-commerce, we must still critique the efficacy of BNPL in the longer term.

The “Self-Approved” Consumer

While the BNPL trend will probably not slow down any time soon, there are some significant drawbacks. Unlike applying for a credit card, BNPL programs don’t subject consumers to hard credit inquiries before allowing them to access their services. It’s quick and easy, which is one of the reasons it’s so popular. But the expediency with which consumers choose the payment method is a recipe for misunderstanding (or entirely disregarding) the terms of use. Depending on the provider, missing a payment could result in a costly late fee or transferring the outstanding balance, with interest, to a debt collector.

BNPL comes with many of the same risks to consumers and lenders as those associated with credit cards, regardless of how these platforms are being marketed. And over time, as BNPL evolves as a credit tool, it is reasonable to assume that consumers will treat these installment payments the same way as they treat their credit card bills. Many will pay on time and without issue, and many others will miss payments and find themselves in debt.

Defaulting on BNPL loans is already happening on a considerable scale. According to a joint survey conducted by Credit Karma and Qualtrics in December 2020, 42% of Americans have made purchases through one BNPL platform or another, with over a third (38%) reportedly having missed at least one payment. Of those who missed payments, 72% reported seeing their credit scores drop as a result. And according to a report in the Financial Times, the default rates of Swedish BNPL provider Klarna had doubled in Q2 of this summer. Considering Klarna’s self-reported consumer base of over 90 million, the development should not be ignored.

Profitability is an Uphill Battle for Lenders

By all outward appearances, BNPL is a wonderfully performing product with a virtually inexhaustible consumer base, but the overall business model of BNPL is not nearly as profitable as lenders would like it to be. BNPL’s biggest selling point, being “interest free,” also happens to be its achilles heel.

Lenders do not make money from interest-free loans, and therefore BNPL providers have to take alternative approaches for revenue creation. Currently, BNPL firms earn revenue from fees paid by merchants known as “merchant discount rates” (MDRs), ranging from 2% to 8% (not including any number of administrative costs). This means they earn incremental gains based on interchange fees for credit card transactions, flat per-transaction fees, and a combination of late fees and interest generated from defaulted loans. When compared with the built-in interest model of traditional installment loans, the BNPL model is barely turning a profit.

Because MDRs are costly for merchants, providers can’t raise these rates significantly without the risk of merchants walking away. Unsurprisingly, many BNPL firms are already in the process of reevaluating their business models, with some looking to package their platform with more traditional financial services in order to establish more reliable streams of revenue.

The Regulatory Landscape is Still Developing

Until recently, BNPL providers have dodged the intense oversight that credit card companies face; however, it appears that freedom will be short-lived. Some critics insist that BNPL could ultimately have a negative impact on consumers, which has made the BNPL space ripe for regulations.

Overseas, BNPL giant Klarna has been the subject of heightened scrutiny around its marketing efforts. U.K. regulators reprimanded Klarna in 2020 for a series of social media campaigns pushing the supposed psychological benefits of making online purchases. In Sweden, Klarna’s home country, the government has introduced a law to keep online merchants from featuring BNPL as the consumer’s “first choice” at checkout.

In the U.S., where regulations are a bit more complex and implemented on a state-by-state basis, the Consumer Financial Protection Bureau (CFPB) has begun warning the American public about BNPL’s potential dangers. Given that BNPL is still in its infancy, many believe it is only a matter of time before more broadly applicable regulations take shape, at which point BNPL providers will likely need to make significant changes.

An Evolving Movement

Despite the existing concerns, the frequency and enthusiasm with which consumers are engaging with BNPL platforms does seem to indicate a positive impact, as well as an expectation that the trend will remain strong for the foreseeable future. And with so many companies adding their names to the BNPL hat in the past year, this trend is one to keep a close eye on. The only certainty is that the BNPL industry will continue to constantly evolve, and we expect that consumer behavior over the next year, as well as investor activity, will tell us more about the longevity of the novel pay-by-installment model. As with most emerging trends in fintech, time will ultimately paint the most reliable picture of BNPL’s lasting contribution to the space.