Hey all, Jason here.

I’ve been wanting to write something on the evolving “buy now, pay later” space, and with Affirm’s S-1 filing and the upcoming shopping bonanzas of Black Friday/Cyber Monday, this was the week. It’s a bit on the long side, but hope you enjoy.

Rapidly Evolving Payment and Financing Behavior Drives a Changing Landscape at Checkout

If you’re part of the consumer credit or fintech worlds, “buy now/pay later” (BNPL, for short) has become the inescapable trend. Commonly used as a catch-all term used to refer to a variety of products and business models, the category has only accelerated with the impacts of coronavirus; namely, increased online shopping and (at least initially) tightened underwriting from traditional lenders.

It All Started with Layaway…

Merchants have long offered customers credit, both to enable/increase purchases and to encourage customer loyalty.

Layaway -- where you make a partial payment to secure an item, followed by ongoing installments --  initially became popular with the sharp contraction of consumer credit in the aftermath of the Great Depression.

It remained a popular option into the 1960s and 1970s, with merchants from General Motors to Wal-mart and Sears offering it for both big-ticket and day-to-day purchases.

The broader adoption of the general purpose revolving credit card, and the instant gratification that went along with it, that saw most merchants do away with layaway (though it did stage a comeback after the 2008 crisis -- also in response to an unusual credit environment).

Lending at the Point of Sale

“Point of sale” finance, like layaway, also has a long history in retail, and has commonly taken two forms:

• Installment finance (basically, an unsecured personal loan), typically for durable consumer goods like appliances, furniture, and, yes, mattresses. Offered as a longer term (1-5 years) interest-bearing loan, potentially in combination with a promotional rate (eg, 0% for 12 months).

• Store credit cards (Best Buy, Express, Victoria’s Secret, etc.), offered at point of sale (often with a promotional discount). A white-label credit card, these typically feature relatively low credit limits and looser credit policies.

  These enable and encourage larger customer purchases (Average Order Value, AOV) and drive customer loyalty; card programs also generate data for retailer marketing programs.

Defining POS Lending vs. BNPL

A lack of clear definition on what constitutes “buy now, pay later” complicates a rational discussion about the product category and business models of companies in the space.

Looking at the offerings in the space, two clear categories emerge.

POS Lending

“Point of sale” lending, in its current incarnation, evolved primarily as a customer acquisition channel for originating unsecured personal loans.

Rather than competing head-to-head with popular lenders in the space, like Lending Club or Avant, POS lenders partner with merchants for distribution.

Key elements of the business model, like partnering with licensed banks and securitizing loan receivables, are the same.

Compared to the newer breed of pay in 4 “buy now, pay later,” POS lending:

• is used for larger purchases

• repaid over longer terms

• requires typical credit check/underwriting

• typically (though not always) charges user interest

Affirm pioneered this model starting in 2012, initially working with popular direct-to-consumer brands like Casper and Burrow.

Several companies that began as POS lenders (including Affirm) have also begun offering “pay in 4” type products.

Buy Now, Pay Later (Pay in 4)

I’m defining “buy now, pay later” more narrowly than some as the “pay in 4” options that have become increasingly pervasive.

The key elements of BNPL are:

• typically smaller purchases

• no credit check/traditional underwriting. May use ‘soft check’ as part of identity verification, but not for underwriting; for example, Sezzle states:

To help prevent fraud and verify your identity, we do run a soft credit check (or "soft inquiry") when you sign up with Sezzle. This has no impact on your credit score.

At this time, we do not report your Sezzle usage to any credit bureaus, so your Sezzle history also doesn't impact your credit score (either positively or negatively).

• BNPL services do not furnish data to credit bureaus (this debt is invisible to other creditors)

• no interest or fees to user (if paid on time)

• typically, user pays 25% at time of purchase and three additional payments in two week intervals

• user links BNPL service to a debit/credit card at time of purchase to automatically draw these payments

With low amounts, alternative underwriting / lack of reporting to bureaus, and short repayment timeframes, aspects of BNPL share commonalities with a different, much-criticized product: payday loans.

Key POS Lending & BNPL Players in US Market

What Trends Are Driving Both POS Lending & BNPL?

POS lending and BNPL options are popular with younger Millennial and Gen Z consumers for a number of reasons:

• Lower penetration of credit cards, particularly among millennials

• Less well-off than members of earlier generations at same age: lower earnings, fewer assets, less wealth

• Facing significant student loan debt

• But similar consumption preferences to prior generations

Data from Australia (may not generalize to the US) show a clear pattern of lower credit card adoption and higher BNPL penetration in the 18-24 and 25-34 age groups:

• Perceived as more transparent. Because BNPL and point of sale financing are close-ended credit products, the total cost is knowable upfront - this gives borrowers more of a feeling of ‘control’ vs. a credit card.

• BNPL split in 4 options may not be perceived as ‘debt’ at all, as they are 0% APR / no fee (if paid on time).

• Low friction and convenient. POS financing and BNPL options are designed to maximize convenience, in order to enable transactions a customer might otherwise not make and to increase purchase size.

  The user experience is optimized to be as quick as possible (to the point where users may not know what they’re agreeing to.)

• Low loyalty. Because the primary driver of POS/BNPL product selection is what the merchant makes available at checkout, there’s little to drive loyalty to a specific provider.

  POS/BNPL companies attempt to address this by offering shopping within their apps/websites and, increasingly, a virtualized card option that allows consumers to use them at any merchant. It’s unclear how effective either tactic is at driving user stickiness and increased volume.

Market Penetration, User Frequency & Stickiness

The most commonly cited statistic I found was from The Ascent (Motley Fool) stating that 37% of consumers have used a BNPL option.

I find that very difficult to believe, and there don’t seem to be reliable penetration/usage stats for the US market. “Pay in 4” usage isn’t reported to credit bureaus, making it harder to measure.

Looking specifically at BNPL “pay in 4” providers in the US, I would guess that 5-10% penetration is more reasonable, and that a small number of users account for a large share of usage across multiple BNPL providers.

On the POS lending side, the size and growth of the market is more clear:

Incumbent challenges

Upstart POS lenders and BNPL providers are facing a number of challenges as incumbents push back on threats to their businesses.

Chase “My Chase Plan” and American Express “Pay It, Plan It”

Banks with large credit card businesses recognize the threat from POS lenders like Affirm. Their response has been, essentially, a UX sleight of hand: after a consumer has made a purchase above a certain amount, allowing them to select and convert it into a sort of installment loan, whereby a specific part of their monthly payment goes toward that transaction.

This approach faces a number of challenges:

• it’s the opposite of convenient - a user must choose to log in a make this choice separate from the purchasing experience. 

• anecdotally, the terms available when selecting a plan are limited and don’t compare favorably to POS/BNPL options

Banks with credit card businesses have little incentive to pursue originating loans at point of sale, as it is perceived as cannibalizing their existing credit card business.

The result may be losing that business altogether.

MarcusPay by Goldman Sachs

Unlike Chase or Amex, Goldman is offering a true point of sale lending option under its Marcus brand (and has little credit card business to cannibalize).

The offering launched in the early stages of the coronavirus pandemic with an unfortunate partner in JetBlue, but expect to see more from Goldman Sachs here -- possibly via API / Banking-as-a-Service type integrations as part of its broader lending and technology strategy.

Visa

Visa is working on a number of projects to allow card issuing banks to offer installment-style options directly at the point of sale, instead of ‘after the fact’ like Chase and Amex’s current approaches.

If executed well and at scale, this could pose a threat to startup POS lenders.

Paypal

While Paypal has long offered a line of credit product, it has expanded into the ‘pay in 4’ category. With an existing, large merchant network, this may be the most serious threat to startup POS lenders and BNPL, if Paypal (…and Venmo) can deploy a competitive user experience at checkout.

Risks to POS Lenders & BNPL

In addition to competitive threats, there are other risks facing POS lenders and BNPL providers.

Credit & Fraud Risk

The BNPL side, given its newness and non-traditional underwriting, may face both fraud and credit risk challenges. In Australia, an early adopter of BNPL, as many as 21% of users had missed a payment.

Equifax has detailed potential risks in merchant defaults, merchant fraud, first party user fraud, and of course risk of default.

Addressing these risks effectively would mean adding friction to both the merchant and the user experience.

Regulatory Risk

BNPL is relatively untested on the regulatory side. While the products generally are 0% APR and no fees, charges do accrue if users pay late.

With underwriting that doesn’t utilize bureau data, it’s difficult to see how BNPL can accurately assess users' ability to pay. Regulatory action is typically tied to perception of consumer harm; if that becomes the case, BNPL providers may face increasing regulatory scrutiny.

In the UK, lead regulator the FCA has already announced it will investigate BNPL firms’ affordability checks.

Merchant & Customer Churn

Customers value convenience and tend to use a specific POS or BNPL provider because it is offered on a merchant’s site. This makes POS/BNPL providers highly dependent on merchants to drive their business.

For merchants, there is declining marginal benefit for adding additional POS lending or BNPL partners. With simple front-end integration, merchant relationships with POS and BNPL may not prove to be all that sticky.

If a POS lender or BNPL service is overly dependent on a single merchant, this represents an obvious risk to its business; for instance, Peloton drove 30% of Affirm’s revenue in the quarter ending Sept 30.

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