Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Is Buy Now Pay Later setting a holiday debt trap?

There are few places where financial innovation is more evident than the choice to defer payment for online purchases. Buy Now Pay Later (BNPL) options from about a dozen fintech providers like PayPal, Klarna, and Affirm offer customers instant credit at checkout and allow purchases to be stretched over 4 interest-free payments. Adoption of BNPL has grown dramatically since 2019, primarily among Millennials and Generation Z.

Yet several studies raise concerns over the growing share of users who are already in or nearing financial distress. BNPL borrowers on average are more likely to be heavily in debt, have other credit delinquencies, carry high-interest credit card balances, and rely on costly alternative services like payday and pawn loans. Forecasts for increased use of these retail loans during the holiday shopping season could spell trouble for the most prolific users.

Online shopping checkout often includes a Buy Now Pay Later option (also called a point of sale or POS loan). Selecting this button allows you to complete the purchase with payments spread over several installments. The payment processor runs a “soft” credit check (which does not affect your FICO score) and, if approved, presents a payment plan or series of automatic drafts from your bank or credit card account. These loans are not reported to the credit agencies (unless the buyer misses a payment), and sellers that partner with these fintech processors incur typical fees of 3-6% of the purchase price. Roughly 70% of applications are approved including many to customers with subprime credit scores or even delinquent payments on other loans.

The attraction for merchants is evident. According to data form, a BNPL option increases the likelihood of completing a sale by 20% and results in a 30-50% boost in average order size. For users of the instant loan option, the benefits are more ambiguous.

A detailed review of BNPL users by the Consumer Financial Protection Bureau confirms some concerning trends that many financial counselors had suspected. Consumers using the option are predominantly younger (Millennials and Gen Z), they are not poor, and they have access to and utilize other sources of credit. But they are overindebted as a group. The CFPB found for example that 69% of BNPL users carried a balance on at least one credit card for some period during the previous year compared with 42% of non-users, and the median sum of credit cards balances for users was a whopping $24,679. The average balance among all Americans is around $6,000.

Those who used Buy Now Pay Later had significantly higher debt in other areas as well. They are 2 times as likely to carry student loan debt (due in part to their age cohort), 3 times as likely to owe other personal debt, and 4 times as likely to have taken out a payday loan. In fact, users on average utilized more of every credit product except, interestingly, mortgages. They are less likely to own a home, but 2 ½ times as likely to have bounced a check in the last 12 months.

In addition to being more indebted, BNPL users are on average more financially fragile. The CFPB study found that credit card utilization rates (percent of the credit limit used up) fluctuated between 40%-50% for BNPL users, compared with around 30% for non-users. Utilization of 30% is generally considered the threshold for financial risk. And indeed, BNPL aficionados had broadly lower average credit scores: 580-669 (considered sub-prime) for users versus 670-739 for non-users. A research paper from the Federal Reserve Bank of New York found that one third of all BNPL shoppers had FICO scores below 620, and surprisingly discovered this group of consumers was offered the option more often than shoppers with scores above 760, suggesting the possibility that retail loan offers are specifically targeted at less financially secure consumers.

The Fed research also found that BNPL customers spent 20% more than non-users, and that 10% ultimately transferred the loan balance to a credit card.

As one might suspect from this data, BNPL users struggle more to meet their debt service obligations. They are 2 ½ times as likely to have experienced a payment delinquency over the past year. According to the CFPB, a full 33% say the primary reason they rely on Buy Now Pay Later is because their credit cards are maxed out. Data firm Morning Consult reports that one quarter of BNPL users missed a payment in August, triggering late fees and interest charges negating the financial benefit of the service. Meanwhile, use of BNPL is forecast to grow by 25% over the next 3 years.

All of which presents a cautionary tale for the holidays. Adobe Analytics expects holiday BNPL use to increase 17% over last year’s shopping spree. And in 2020, when BNPL was relatively young, 70% of purchases were luxury and designer goods. Increasingly, and alarmingly, consumers are financing essentials like food and household goods. Adobe expects a 37% jump in use of BNPL to buy groceries this year. Not a good sign just as student loan payments resume.

Financial innovation often brings convenience and added utility into our lives when used responsibly. Buy Now Pay Later can be a useful tool but its ready availability can also reinforce existing financial stress. The holiday season is a good time to budget carefully and avoid overspending when it’s so easy to delay the reckoning.

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