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A Better Approach to ‘Buy Now, Pay Later’

Concerns are growing that the boom in short-term financing that has fuelled apparel sales is saddling a growing number of vulnerable shoppers with debt they can’t pay. But the concept can still benefit brands, lenders and consumers, with a few key changes.
Consumers are spending more as pandemic restrictions ease.
Consumers were quick to embrace 'Buy now, pay later' options, but a growing number are falling behind on payments. Source: Shutterstock (Shutterstock)
By
  • Maura Brannigan
BoF PROFESSIONAL

Key insights

  • ‘Buy now, pay later’ services that allow consumers to pay for purchases in instalments have driven higher spending at apparel retailers in recent years.
  • Defaults are on the rise, and investors worry higher interest rates and a slower economy will spell trouble for the model.
  • Apple this week announced it was launching a BNPL service, putting it in competition with Affirm, Klarna, Afterpay and others.

Fashion brands were some of the earliest and most enthusiastic supporters of the “buy now, pay later” concept, which allows customers to split up payments over weeks or months. For retailers, the payment option drew in a whole new class of consumers, especially young shoppers who didn’t have credit cards or savings.

Now the bill is coming due.

A growing number of customers are missing payments on their clothes and makeup, amid soaring inflation and slowing economic growth. Investors fear a wave of consumer defaults on these loans, especially if the economy tilts into recession. In May, the Wall Street Journal reported that Klarna is seeking $1 billion in funding at a $30 billion valuation, down by one-third from June 2021. Shares in Affirm are down about 85 percent from their November peak. Regulators are circling.

Retailers aren’t likely to get caught up in the financial fallout — it’s the BNPL firms that are on the hook for those delinquent loans. But they could see a drop in sales if their customers become wary of using these services or are cut off as lenders tighten their standards. Brands also risk damaging their reputation, especially if consumers come to feel they were misled about the consequences of loans they impulsively took out just before hitting purchase.

Despite its recent problems, the category looks set to keep growing: earlier this week, Apple announced it was launching a BNPL service. If deployed responsibly, buy now, pay later can benefit lenders, retailers and consumers, experts say. But changes to this emerging industry are needed: BNPL firms can reposition their instalment plans as a way for young and low-income consumers to build credit and do a better job screening out those who are most likely to fall behind on their loans. Retailers can do more than add a button from Klarna or Affirm alongside the credit and debit card options on the checkout page; they can educate consumers about how instalment payments work and be as transparent about the terms of these loans as they are about shipping.

“The threat is that ‘buy now, pay later’ platforms can disguise debt, leaving consumers unprepared to answer for their financial actions,” said Cassandra Napoli, senior strategist, insight at trend-forecasting agency WGSN. “Brands have a responsibility to do the right thing for users and consumers, especially as ‘buy now, pay later’ services expand.”

Change Is Coming

The outright number of consumers who have defaulted on their buy now, pay later loans is still relatively small; at Affirm, 3.7 percent of loans were 30 or more days past due at the end of March. But that share is up from 1.8 percent in June 2021. It may rise further. A 2021 Credit Karma survey found that of those who have used short-term financing, 34 percent have fallen behind on one or more payments, while 30 percent of Gen-Z customers have missed two.

Rising interest rates are another problem: they increase the cost for the lenders themselves to borrow, making cheap credit more expensive for these firms to offer shoppers.

The Consumer Financial Protection Bureau, a US regulatory agency, opened an inquiry into buy now, pay later credit systems in December, citing accumulating debt and data harvesting, among other concerns. The European Union, meanwhile, began the process of tightening its oversight nearly a year ago, with a proposal requiring “buy now, pay later” firms to operate more transparently with consumers. Earlier this year, the UK’s financial regulator ordered consumer credit firms to be more transparent about their terms and take other steps.

Some of the big BNPL firms are making it harder for high-risk shoppers to take out loans. SoftBank-backed Klarna this month began sharing data on its 16 million British customers’ payment history with credit agencies, meaning their loans will begin appearing on credit reports.

That addresses a major complaint of critics of instalment payments: that lenders don’t really know whether borrowers have the ability to pay them back. According to Fitch Ratings, the lack of reporting makes it easier for consumers to play BNPL firms off each other, borrowing and defaulting on loans from multiple lenders while appearing to have a pristine credit history.

Linking BNPL with credit agencies could allow a wider group of consumers to build credit histories, which are necessary to gain access to many benefits of the financial system, said Vijay Viswanathan, associate dean of Integrated Marketing Communications at Northwestern University’s Medill School of Journalism.

“Customers who make regular ‘buy now, pay later’ payments should be able to build credit, even if it’s not through a credit card,” said Viswanathan. “Credit-rating agencies should work with ‘buy now, pay later’ lenders and capture this data to help segments underserved by established banks and credit card companies to build credit.”

Leading With Education

Retailers have mostly left it up to BNPL firms to educate consumers on how their loans work. For them, the payment plans help shoppers buy what they want, when they want; Affirm’s retail partners see cart sizes increase an average 85 percent when using their service, said the platform’s Chief Commercial Officer Silvija Martincevic.

But leaving it to the BNPL sector to educate consumers about credit — or not — is a mistake, said Napoli, the WGSN strategist.

“The threat is that buy now, pay later platforms can disguise debt, leaving consumers unprepared to answer for their financial actions,” she said. “Brands have a responsibility to do the right thing for users and consumers.”

Napoli suggests that retailers roll out financial literacy tools to help young shoppers navigate BNPL platforms and monitor their spending, with branded education materials and budgeting tips that can be shared via their influencer partners.

At Afterpay, an Australian BNPL firm, customers can set up budget trackers to help manage when instalments are due and set up reminders ahead of their scheduled payments. Nick Molnar, co-founder and co-chief executive, said the company “has become a helpful budgeting tool” in and of itself. Affirms’s Martincevic said the company’s underwriting technology approves customers “only for the amounts we believe they can comfortably afford to repay.”

Viswanathan said the fundamental problem is that many shoppers don’t think of BNPL financing as debt.

“From a financial management perspective,” said Viswanathan, “we should be aware of how making smaller payments over a period of time can affect other goals and events in the long run.”

Moreover, education can be difficult when brands see BNPL primarily as a way to nudge consumers to spend more. The wide array of plans, each with its own schedule of payments and interest rates, can also be confusing. BNPL lenders typically don’t charge interest for smaller payments made over a few weeks, but annualised rates can be as high as 30 percent for big-ticket items financed over months (the average credit card APR is about 16 percent, according to the US Federal Reserve).

“If brands use ‘buy now, pay later’ ethically, to do what they’re designed to do, they can drive long-term sustainable growth,” added Viswanathan. “If used unethically, they’re reducing themselves to loan sharks and doing a tremendous disservice to their customers, their communities and the economy.”

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