The Art of Balancing Buy Now, Pay Later

BNPL is one of the hottest trends in payments and an incredibly hot area of investment right now. The trend is not expected to change anytime soon given the increasing number of BNPL firms attracting investments, and growing deal sizes and valuation. Americans are expected to make an estimated $80 billion worth of BNPL purchases in 2022 and BNPL transactions are expected to reach 10% of all e-Commerce transactions by 2024 amounting to $120 billion.

Installment payment plans are nothing new. Retailers like electronics and furniture stores have allowed customers to pay off large purchases in installments for decades. BNPL brings the concept into the digital age by allowing any retailer to offer installment payments for any product, no matter how small, both online and in-store.

Unlike other payment types, customers are often exposed to BNPL at different points in the buyer's journey. For example, when browsing products online, they may see the BNPL installment price on the product page, which helps make the product feel more affordable. Consumers can also choose BNPL at checkout. In addition, some issuers and financial institutions are now offering buy now, pay later so that cardholders can pay for specific transactions in installments, allowing them to better manage cash flow and potentially avoid late fees.

BNPL is considered the evolutionary descendent of credit cards. Just like music went from CDs to MP3s, and most recently, streaming music; Credit Cards went from physical cards to virtual cards and instant issuance to BNPL with experience just like streaming credit.  

For consumers

• It’s a better (and modern) form of credit compared with credit cards. BNPL is low-cost, simple, transparent, and provides a line of sight for customers to pay off balances;
• It’s deeply integrated into the buying and checkout journey making it easy for consumers to purchase an item;
• It helps with budgeting;
• It’s easy to use and makes products more affordable;
• It provides additional credit to those who have reached credit card limits and in some cases to those that don’t even have credit.

For merchants

• BNPL has helped increase conversion rates by 2-3 times and average cart sizes by 20%-30%;
• Customers shop 10%-25% more frequently if offered a BNPL option;
• BNPL is becoming a customer acquisition tool and merchants are increasingly subsidizing BNPL offers as opposed to funding deep discounts on products;
• It helps ‘influence’ purchase decisions if BNPL is moved up front in the pre-purchase phase of the customer journey as opposed to just checkout;
• Unlike credit cards, most BNPL providers assume fraud and chargeback risks.

In a rapidly growing market, where both customers and merchants love the product, everyone from banking and FinTech firms to Big Tech firms like Amazon and Apple are rushing to offer the product.

However, these providers face a significant problem.

Lenders don’t make money on ‘interest-free’ loans. Compared with traditional installment loans, BNPL makes less money for lenders with the ‘current’ business model in place today.

The primary revenue streams for BNPL loans include the following:

• Merchant Discount Rate (MDR), i.e. fees 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 other fees earned — does not equal the money made from a traditional installment loan for the same loan amount.

Let’s look at the two scenarios below to illustrate the difference:

Note: Assuming zero cost of capital, zero servicing fees, no late fees etc. for simplicity
 

As shown above, for the same loan amount, lenders make less than half of 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, merchant discount rate for BNPL loan would need to be about 20% to make a net profit of $430.

BNPL is expensive for Merchants: As mentioned, merchants that accept BNPL 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.

BNPL has an uncertain regulatory landscape which is a risk to BNPL firms. 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. 

In December, the Consumer Financial Protection Bureau (CFPB) issued a series of orders to five major BNPL providers to collect information about the risks and benefits of their solution. The CFPB is concerned about the potential for consumers to accumulate debt too quickly.

BNPL can confuse customers. 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.

BNPL creates a consumer spending behavior possibly worse than 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.

Banks and FinTechs firms that provide BNPL will need to balance the following elements to build profitable BNPL businesses:

1. Focus on Profitable market segments. Find market segments where use of financing a purchase is high, average loan size is also high, ideally greater than +$2500, and default rates are low. Retail eCommerce segment where the average loan is less than $500 and competition is high is not the best segment for a new BNPL provider to enter.
2. Improve pricing strategies (for pricing arbitrage). Create micro segments of customers and find ways to price each customer segment differently based on risk profiles. Finding pricing arbitrage opportunities using customer data is one way to build a profitable BNPL loan portfolio.
3. Focus on providing higher approval rates. Improve underwriting by using alternative data, such as mobile phone usage, utility, rent payments, behavioral data etc. Ideally leveraging attributes provided by credit bureau data. In some market segments, BNPL players will need to provide greater than 90% approval rates to be a successful and viable player
4. Offer a mix a lending products. The mix should include other lending products such as traditional installment loans, same-as-cash, no-interest-no-down, other promotional products, leases, etc. each of which has different profitability performance. Offering a diversity of products to merchants is one way to ensure the business is profitable
5. Add other Banking Products. Add other financial services products, such as credit cards, savings account, wealth and investment tools, and even crypto, in the business. Cross-sell these products to customers, ideally where the need has been identified and customers presented with a prequalified offer by leveraging data collected through BNPL usage behavior. BNPL providers will need to build a comprehensive roadmap of additional products to offer to customers, if they are a BNPL ‘only’ provider.

BNPL is here to stay. Banks and FinTechs that build the right business and pricing strategies, comprehensive product roadmaps, focus on digital delivery and experiences, and build robust risk and compliance programs will be ones that create profitable and stickier platforms for both merchants and consumers.

Leveraging our deep expertise in financial services and Payments, including former entrepreneurs and business executives on staff, Sia-Partners can help with the following to help accelerate your successes in the market:

• Strategy, go-to-market, and implementation plans, including program management
• Design Financial Services Product roadmaps and Pricing Strategies
• Design and build Digital Products and Experiences that leverage Sia-Partner’s state-of-the-art AI and Data Science capabilities, including integration with Payments systems and FinTech platforms
• Guidance on Credit and Underwriting Models to increase approval rates and reduce defaults and losses
• Build best-in-class Risk and Compliance programs designed to reduce risk in any BNPL program