The second explanation has to do with how pay-in-four taps into human psychology and consumer behaviour. It satisfies what behavioural economists call our present bias, which drives the desire for instant gratification.
It also exploits the fact that unexpected losses almost always exceed unexpected gains: Humans tend to discount the probability of bad things happening in the future (we’ll lose our job or the car will need repair, making it hard to repay) and overestimate the probability of good things to come (we’ll be able to work overtime next week, so it’ll be easy to repay).
And because we are much less sensitive to the pain of a price tag if individual chunks feel affordable (parting with, say, 25 of our hard-earned dollars today, then three more times in the near future, hurts less than parting with $100 at once) we are more willing to spend more in the aggregate.
That in turn explains why merchants love pay-in-four. But even as the industry has grown spectacularly – the number of people who’ve tried the services in the US has quadrupled every year since 2018 – nearly everything about the business environment has recently turned more serious and challenging.
Eyeballs, dollars and data
Shop online, and you’re bound to encounter offers from Afterpay, Klarna, or Affirm to let you split purchases up to $2500 into four instalments. You enter the usual information, concluding with a credit card, debit card, or bank account number to pay one-quarter of the total price upfront.
The companies then use proprietary predictive models to assess the riskiness of lending you money to complete the transaction. Requests get approved within seconds. An email invites you to download the phone app, which lets you track the remaining three biweekly payments, which can be automatically charged to the card or account entered at checkout.
It also functions as something more clever: an online shopping mall, where you can browse the wares of brands that have formed partnerships to accept that BNPL provider as a form of payment. Eyeballs, dollars, and data flow as a result.
The arrangement is like lay-by, but in reverse. Make your payments on time, and the pay-in-four model is all upside: You’ve borrowed money free of any interest. But fall behind on your payments, and you might get hit with late fees from the BNPL provider.
If your account balance is running low, the auto-deduction might trigger an overdraft fee from your bank. If you use a credit card and don’t pay off the balance in full, you’ll end up paying interest indirectly. BNPL companies slam the evils of credit cards but accept them as a way for users to pay on their platforms.
Merchants benefit from accepting credit cards – and paying a transaction fee averaging 2 per cent – because doing so increases sales. BNPL one-ups the incentive: Merchants pay an even higher fee – up to 6 per cent for pay-in-four – but are rewarded with more completed transactions (less “cart abandonment,” in industry parlance) and even higher sales.
These fees from merchants make up the single biggest source of revenue for many BNPL companies, a fact they cite as proof that their interests, unlike the interests of credit card issuers, align with those of customers. Card issuers, by contrast, earn the vast majority of their revenue from fees and interest heaped onto users who don’t pay off balances in full, and on time.
There is research showing a correlation between boredom, browsing the internet on your phone while lying in bed, and spontaneous shopping sprees – so maybe it was no wonder that the BNPL industry took off as the pandemic dragged on, making hay and minting billionaires.
Consumer advocates watched with concern: What exactly was BNPL, anyway? The companies operating under the moniker offered significantly different services. Afterpay stuck to interest-free pay-in-four and, like Klarna, charged late fees. Affirm and Klarna did pay-in-four but also issued interest-bearing, long-term, instalment loans.
The lack of uniformity could be confusing. And it wasn’t clear what laws or consumer protections applied. Congress had passed the Credit Card Accountability Responsibility and Disclosure Act of 2009 to make it harder for credit card companies to market to young people and risk saddling them with debt, and here were BNPL companies, unbeholden to the law and appearing to do just that.
Hard to categorise
Was pay-in-four even credit? New services can be hard to categorise, and, just as deferred-presentment providers (aka payday lenders) did back in the 1990s, BNPL companies took semantic liberties. Afterpay referred to itself as a “budgeting tool.” Klarna called itself a “global payments and shopping service.” As time passed, people called their bluff.
“If I spend your money now, and then I pay you back with my money later, common sense would dictate that I am borrowing from you and that you are lending to me,” Ritchie Torres, a New York Democrat congressman said at a US November hearing on BNPL. Regulators in California and Massachusetts have accused BNPL providers of offering illegal loans and forced them to register as licensed lenders.
The US Consumer Financial Protection Bureau (CFPB) took the first step toward bringing BNPL products under its regulatory umbrella in December, when it ordered companies to submit information about industry practices and risks.
The CFPB’s very creation was predicated on the need to oversee the surging, loophole-enabled popularity of innovations like BNPL loans, says Robert Lawless, a professor and expert on consumer finance at the University of Illinois’s College of Law. “Financial regulation is a game of whack-a-mole,” Lawless says. “There’s always going to be some new device or transaction that the existing statutes don’t cover, so we need a regulatory agency to track these things because Congress – even a functioning one – can’t keep up.”
Why didn’t the CFPB act sooner? The rise of BNPL coincided with the era of Donald Trump, whose administration was hostile to the agency and its mission.
The lag may have also been driven by data: The CFPB uses consumer complaints to help guide where to use its limited time and resources, and the number of BNPL-related complaints didn’t explode until 2021. This year complaints are on pace to blow past last year’s total of 547. The most common ones concern incorrect information on credit reports and attempts to collect debt that isn’t owed.
In an interview, Rohit Chopra, appointed by US President Joe Biden to lead the CFPB, is clear about the benefits and risks of BNPL. Enabling people to overextend themselves, he says, has “led many people to believe that what they thought was affordable or what they thought was free was not”.
Chopra issued the request for information on BNPL companies two months after assuming office and says he expects the agency to issue its initial report on the industry before the end of the calendar year.
The CFPB could eventually require companies to abide by consumer protection laws that don’t now apply. It could subject the biggest players to regular examinations. Beyond rule-making, which can take years, the bureau can issue best practices and fines for noncompliance. The industry may complain this is regulation by enforcement, but it’s where the CFPB can move the fastest.
Here comes Apple
Opinion is divided on whether increased regulation could curb the BNPL industry’s growth. Juniper Research suggests regulatory changes will merely place it “on a more secure footing.” Investors, however, have become increasingly worried about the viability of companies reliant on lending to mostly younger, often subprime consumers, particularly if there’s a recession.
The shares of Affirm and Block, Afterpay’s parent, have lost more than 55 per cent of their value since the start of the year. That’s made it harder for Klarna, which is private, to raise capital: Its July funding round slashed its value to just under $US7 billion ($10 billion) from $US46 billion in mid-2021.
Losses, meanwhile, have increased. risen. In January-March, Block’s more than quadrupled compared with the year-earlier period to $US91 million, driven primarily by delinquency on Afterpay loans. In that same quarter, Klarna said credit losses jumped 51 per cent, to 1.19 billion Swedish krona because of its expansion in the US, France, and elsewhere.
At Affirm, write-offs almost quintupled to $US67.2 million. (Lenders write off a loan they’ve decided a consumer isn’t going to repay, refer it to a debt collector, and record it as a loss on their books.) Competition has also increased, with some two dozen BNPL-branded companies now operating in the US, the Federal Reserve Bank of Kansas City says. In June, Apple said it will introduce a pay-in-four option called Apple Pay Later. PayPal Holdings inaugurated its version in August 2020. A race to the bottom has begun, as companies offer ever-lower merchant fees to gain market share. “Lenders will need to find other sources of revenue to maintain growth and profitability,” the CFPB said in December.
Because it’s new, BNPL hasn’t been tested during a meaningful, economic downturn. With inflation high, money doesn’t go as far, which suggests demand for BNPL could rise, as it did for traditional lay-by during the Great Recession. But if people curb spending altogether, usage could dip. The number of people unable to repay their loans could climb. The industry is in the early stages of a defining test.
In early 2018, four years after its initial crew gathered in Melbourne, Afterpay exported its pay-in-four model to the US. Klarna and Affirm already existed, but neither offered a pay-in-four service yet.
Klarna, which began as a payments processor in Stockholm in 2005, is now the biggest BNPL provider by sales volume, with 400,000 merchant partners and 150 million active users in 20 countries.
San Francisco-based Affirm started out 10 years ago offering long-term instalment loans. It earns a good chunk of revenue from interest on them, albeit in a way it bills as more transparent than a credit card. Affirm doesn’t charge late fees, but it cuts you off from the platform if you don’t pay. Chief executive Max Levchin founded the company with Palantir Technologies co-founder Nathan Gettings and two others after co-founding PayPal with Peter Thiel and Elon Musk. Levchin is particularly outspoken about what he sees as the potential for pay-in-four and other BNPL instalment plans to usher in a new era of consumer finance. They’re tools in the service of his bigger vision: “reinventing lending” by “revolutionising” the credit-scoring system.
It’s hard to be a fully functioning member of the economy and society without access to credit. For decades, credit-reporting companies Experian, Equifax, and TransUnion have functioned as gatekeepers – central repositories for data about the income, assets, payment history, and outstanding debt of American consumers. When you apply for a credit card or a loan, lenders use that data to help determine your creditworthiness, or how big of a credit risk you might pose.
This system has long been reviled. About 106 million Americans are considered “credit invisible,” “unscorable,” or subprime and below, data shows. Poor people, people of colour, immigrants, and young people disproportionately fall into those categories and get cut off from traditional banking and the advantages it can bring.
Black and Latino people tend to have lower credit scores. Therein lies the potential for fintech innovation to mitigate racial, financial, health, and wealth gaps, Kristen Broady, at the time a fellow at the Brookings Institution, said at the November BNPL: “Through technology and automation, they can reduce costs and prices, speed up delivery, and increase convenience for underserved populations.“
BNPL companies speak in Silicon Valley terms. The legacy credit system is broken and unfair; what they’re creating to replace it will make the world a better place. Speaking from his home office, Levchin describes his inspiration to create an alternative. He came to the US from Kyiv as a teenager and tanked his credit score in his penniless youth. It took years for it to rebound. “This is a personal conviction based on direct experience,” he says. “The system was ripe for fixing when I experienced my road bumps all those years ago, and I don’t think it’s changed all that much.”
That’s where the algorithms come in. Instead of running a one-time assessment on the creditworthiness of an individual borrower, as credit card issuers do before they issue a card, BNPL companies assess the risk of each individual transaction. Making every transaction “an explicit borrowing event,” Levchin has said, protects companies from excessive risk and borrowers from overextending themselves. And it qualifies a lot more people for loans.
Take a $5000 line of credit: A traditional lender must factor in a borrower’s income, expenses, and obligations. It uses credit scores to predict the likelihood that the borrower will pay 90 days late (or more) over the next 24 months. Contrast that with a $500 loan for headphones. The BNPL provider receives a relatively hefty 25 per cent down payment (the first $125 of four payments) upfront, and need only estimate the likelihood of default on the remaining balance over the next six weeks. The smaller-dollar nature and shorter repayment window add up to lower risk.
The precise components fed into the algorithms aren’t disclosed.
Afterpay’s models include “hundreds of internal and external data variables and features,” says spokeswoman Amanda Pires, offering no additional details. Affirm’s “proprietary technology that we’ve been developing for a decade” uses “proprietary data we’ve been building up for nearly as long,” Levchin has said. “Our process involves looking at credit report data, but could also involve some Affirm-specific stuff, like what we know about the merchant and the thing they are about to sell you.”
The resulting loans get branded by BNPL companies as tools of empowerment and freedom. Users skew young – so less financially experienced and savvy, by definition – and female, many with low to moderate incomes. BNPL, the companies say, transforms them into responsible customers shielded from predatory lenders – and advances, loan by loan, the cause of financial inclusion.
The industry has faced accusations that it emotionally manipulates users and glamorises debt, using social media influencers to drive adoption and marketing slogans such as this one from 2018: “Broke AF but strongly support treating yourself? Afterpay is now in-store.”
Using pay-in-four for groceries and other everyday essentials suggests economic precariousness, says Andrew Kushner, policy counsel at the Centre for Responsible Lending in Oakland, California. That, he says, reinforces the need for stronger protections, “so it’s not going to cause more harm down the line.”
The companies say their built-in protections enforce responsibility. They do such things as cap late fees at 25 per cent of the purchase price or start you with a low ceiling of $100 before increasing your limit after you’ve demonstrated your ability to pay on time.
But plenty of people truly don’t have the wherewithal to take on debt, and BNPL offers the chance to do it anyway.
The companies have been sued by consumers who got hit with bank overdraft fees they didn’t expect. A recent study by economist Amy Crews Cutts showed 17 per cent of BNPL borrowers used the service after maxing out their credit card, and almost half made purchases they acknowledged they couldn’t otherwise afford. In a survey of more than 1000 users, one-third told Credit Karma they’d fallen behind on payments.
‘I missed one payment’
Whether disdain for credit card issuers runs as high as the BNPL industry says, consumers have developed certain expectations about paying with credit. One is that they will boost their credit score by paying bills on time. Historically, though, BNPL providers haven’t consistently reported the existence of a pay-in-four loan or the borrower’s payment history to the credit reporting companies.
That will change; BNPL providers are working with the credit reporting companies to develop a system to do this. But as the CFPB has warned, this lack of reporting has prevented lenders of all sorts from seeing how much a prospective borrower may already owe others.
That can result in a practice called loan stacking – borrowers carrying loans with multiple providers at a time. It’s the result of a system that, if not set up to create problems, doesn’t do enough to prevent them.
Chemareéa Biggs, an artist in New York, is living with the fallout from her own loan stacking. After graduating from the University of Texas, Biggs rented an apartment in Brooklyn, got a job at a museum, and took on freelance graphic design and teaching work. She’s since lost multiple jobs because of the pandemic, fallen into a debt trap she doesn’t know how to climb out of, had her chequing account closed because of repeated overdrafts, and seen her credit score drop some 200 points.
She traces her troubles to a pair of plane tickets, totaling $US607, she purchased on pay-in-four plans through Affirm in October and November 2021. “I missed one payment,” she says, “and that’s when things started to go to shit.”
“The advertising on these things,” she says, “it almost makes spending look like a game.”
BNPL companies don’t force you to buy things, of course, but they do lower the barriers. A Federal Reserve Bank of Philadelphia survey found that contrary to popular belief, convenience, not lack of credit access, was the primary reason people chose BNPL as a payment option.
Sebastian Siemiatkowski, co-founder and CEO of Klarna, told Sifted, a publication of the Financial Times, that he’s questioned internally whether BNPL loans make borrowing too easy. “When it comes to money, friction isn’t a bad thing,” says Alistair Newton, a banking analyst at Gartner in London. “Sometimes a bit of friction in a payment is good.”
Sometimes there’s friction between customers and merchants. The Fair Credit Billing Act guarantees credit card users the right to file complaints about overpayments and billing disputes and requires card companies to investigate and refund any unjustified charges. There is no such framework for BNPL. Because the companies depend so heavily on revenue from merchants, there may be a financial incentive to keep them happy at the expense of customers.
Even if a short pay-in-four plan or a longer instalment loan doesn’t feel relevant today, BNPL providers see a future in which you’ll be a customer soon enough. Klarna and Affirm in particular have ambitions to enmesh themselves further into our fiscal lives.
‘Nightmare of the bank establishment’
Klarna has a banking license in Sweden (though Siemiatkowski says in his Twitter bio that he’s “Trying my best to be the nightmare of the bank establishment worldwide!“) and offers savings accounts to people across Europe. A recent “innovation” is an option called Pay Now, which involves, as the name suggests, no credit at all. You just pay now. Affirm offers savings accounts backed by the US Federal Deposit Insurance Corp. that accrue interest and from which users will soon be able to buy and sell crypto.
Born on the internet, the BNPL industry may see its future growth come from a far bigger market: people buying things in person in actual real life. Klarna now offers a physical plastic card, allowing you to pay-in-four not just via merchants with whom it has partnered but for whatever, wherever you’d like.
Affirm has a card that can act like a normal debit card or enable you to split payments into four interest-free instalments. Levchin has described himself as particularly enthralled that people are using it heavily at Walmart to buy groceries, suggesting it’s “top of wallet.”
Asked if he believes an impending recession will temporarily curb BNPL use or cause it to spike, Levchin demurs. “But I’m pretty confident that three years from now there’ll be a lot more buy now, pay later in the US than there is right now,” he says. His vision involves you using Affirm to buy everything, causing you to abandon credit cards altogether.
“I’m extremely biased, and I’m sort of drinking my own Kool-Aid and trying to sell it at the same time here, but I do see the demand for this credit-card-alternative payment modality just rising among young people, among people who are fed up with the sort of ‘fine print is my business model’ approach that traditional banks have,” he says. “I don’t take it for granted that everybody has to believe in it. But as an entrepreneur, it’s my job to believe that my future is the best one.”
It’s hard to argue against the world BNPL companies say they’re creating –one in which finance is friendlier, transactions simpler, terms more transparent.
In the broader movement to add a certain aesthetic to lending, with vibe-y names, better-looking websites, smartphone apps, and a boatload of marketing, there’s something powerful in rebranding credit and debt as more palatable. It’s just that for the spenders, the risks and responsibility remain the same.
— Bloomberg Businessweek