PDD#20: Buy Now Pay Later explained

Preface

As digital commerce evolved, so too did the needs of consumers, creating fertile conditions for FinTech companies to reinvent credit for the modern shopper. Buy Now, Pay Later (BNPL) is one of those new payment methods that has surged in popularity over last decade, changing how consumers approach short-term financing.

In this article, we explore how BNPL evolved from conventional credit mechanisms, who pioneered BNPL, and how typical BNPL process compares to other existing payment processes. Lets dive into this!

Disclaimer: The information provided in this article is for general informational purposes only and should not be considered as professional advice. The content is based on my knowledge and research, and I have endeavored to ensure its accuracy. However, please note that information can change over time, and I cannot guarantee the accuracy, completeness, or relevance of the content at all times. The views expressed in this article are solely my own and do not necessarily reflect the views of any organizations I am affiliated with.

Buy Now, Pay Later is a financial model that allows consumers to make immediate purchases (Buy Now) and defer payment over a specified period (Pay Later). These loans offer the opportunity to make four payments over a short term (generally six weeks) for the current purchase, with no interest or fees to the customer, hence also called "Pay 4" or "Pay in 4" sometimes.

BNPL - Not just another payment method

BNPL is a type of short-term financing that allows consumers to buy a product or service and split the cost into multiple payments. Typically, BNPL providers offer interest-free installments over a short period, such as 4-6 payments, if repaid on time. BNPL is offered at checkout by e-commerce platforms and retailers, either online or in physical stores.

Customers can use credit cards also for financing, but typically they charge 20%+ on amount not paid by end of month. So a no-fee BNPL installments seems no brainer here. While BNPL is often interest-free for the consumer, merchants typically cover these costs as part of the service arrangement (We will see economics later in this article).

Here is how the two options compare for the customer at checkout:

The concept of Buy Now, Pay Later is not new. The credit lines and the credit cards has been offering consumers similar deferred payment options. the key differentiating point with BNPL is that it is Financing at the point of sale (POS). In post COVID era payment digitization and rising merchant adoption of digital terminals have played a significant role in innovation in this space. In addition, the youngest new-to-credit generation is mobile native, and very comfortable with handling financial decisions while on the move. Their own digital footprint (read data availability), combined with deeply integrated shopping platforms (read data stitching and robust processing power at scale) is allowing for the credit risk assessment to be doable at the point of sale where BNPL is often offered. Thus making it easier for users to opt in, compared to applying for a credit card.

In contrast, if one decide to take the credit line or credit card when making a purchase, then they would need to request these flexible loan products and get a predetermined borrowing limit by their bank/issuer. What customers enjoy with BNPL is instead the relative convenience and loan being tied directly to a retail purchase. This model proved especially appealing to millennials and Gen Z consumers, who were wary of traditional credit card debt. This growth has also increased the scrutiny of BNPL products among investors, industry watchers, and regulators.

BNPL in Status and Usage behavior

• McKinsey study found that BNPL customers are much more active and engaged across transaction volumes, digital app engagement and length of relationship.
• $334bn - Total BNPL transaction value in 2024 is estimated to be $334bn, and expected to rise ?? to $687bn by 2028 (Source: Juniper Research)
• Most BNPL users make on-time payments, but credit scores often subprime (Source: Reuters)
• Most customer choose BNPL for convenience (Source: FRB)

How BNPL works

Lets use our standard payment transaction framework now to understand how payments are processed in BNPL flow.

Step 1: Authorization Request

When Merchant has integrated BNPL provider, and they select BNPL as the payment option at checkout then merchant sends a request to the BNPL provider for authorization. The BNPL provider receives details about the transaction: amount, merchant ID, customer information, and the installment terms selected by the customer.

The BNPL provider checks whether the customer even qualifies for BNPL financing for this purchase based on their business rules. Request may get rejected for example if item is being shipped to non-serviced zip code/region.

Step 2: Financing Verification

In card payments, the acquiring bank (merchant’s bank) verifies the transaction at this stage.

In BNPL transactions, the BNPL provider itself plays the role of the financing entity. It verifies whether the customer meets its internal criteria for the payment plan. This might involve checking for any fraud indicators or verifying basic customer details like identity, past history, real-time behavior and credit behavior.

In some cases, the BNPL provider may work with a financial institution to pull credit or have them assess the risk. A credit check is usually a soft check, that is, it doesn't affect the credit score.

If approved, the provider prepares to issue the loan and settle the payment with the merchant. The BNPL provider's internal system acts like the card network, processing the transaction and taking decision on customer’s installment terms. They may check the customer’s spending limits, past BNPL usage, and overall creditworthiness. If all conditions are met, the provider approves the loan for this purchase.

Step 3: Authorization Response

The BNPL provider sends an authorization response back to the merchant, confirming that the customer has been approved for the BNPL loan. The customer is notified of the approved installment plan, which outlines the payment amounts and schedule (e.g., 4 installments over 8 weeks).

The customer receives their goods or services, and the merchant is paid by the BNPL provider upfront for the full amount (minus fees or commissions charged by the BNPL provider).

Step 4: Settlement, Clearing and Repayment

The BNPL provider immediately settles the payment with the merchant, typically within 1-2 business days. The merchant receives the full transaction amount, minus any fees associated with using the BNPL service.

Clearing in BNPL involves reconciling the installment payments with the customer. As the customer pays back their loan over time, the BNPL provider updates the transaction records and ensures the repayment is proceeding as planned. This also involves reconciling any fees, late payments, or adjustments to the account balance.

The customer repays the BNPL loan in fixed installments, as outlined in the purchase agreement. The installments are automatically deducted from the customer’s linked account (bank, debit, or credit card) on the scheduled dates.

Growth of BNPL

BNPL has surged, especially since the mid-2010s, with companies like Klarna, Afterpay, Affirm, and PayPal's Pay in 4 leading the charge. In the U.S., BNPL usage grew around 300% from 2019 to 2021, and globally, it now represents billions in transaction volume annually, expected to exceed $1 trillion by 2030.

BNPL's appeal has soared in the e-commerce sector due to:

• No interest or hidden fees (if paid within the stipulated time). It is simple, payment schedule is published upfront, so people know what they will be charged.
• Transparent terms and no compounding interest: Unlike traditional loans, where the compounding interest can lead to costly surprises, BNPL offers a transparent payment structure. Consumers can avoid the 'fine print' traps associated with some bank loans—many of which have led to financial setbacks or cautionary tales they've experienced firsthand or heard about from others
• Seamless digital integration: BNPL is often offered at the point of sale, integrated directly into checkout processes, making it easier for users to opt in compared to applying for a credit card.
• Access for those with Lower Credit: BNPL often accommodates consumers with limited or poor credit histories (aka sub prime), expanding access where traditional credit options might be unavailable.

Pitfalls of Buy Now Pay Later loans

The global BNPL market has grown dramatically, expanding into offline retail and even emerging economies. Companies like Uplift allow travelers to split the cost of flights and hotel stays, while healthcare providers are now offering BNPL options for medical treatments.

The early BNPL model has since evolved with several trends and regulators have taken the notice too. As BNPL products have become more widespread, concerns around consumer debt and financial regulation have grown. Many consumers may not fully understand BNPL terms, leading to missed payments or over-borrowing. Regulatory bodies in Europe, Australia, and the U.S. are now considering tighter rules around BNPL to protect consumers.

Some of the key areas of concern on BNPL are:

1. Consumer Debt Accumulation due to people overspending beyond their means, often leading to multiple BNPL loans across various providers. With overlapping payment schedules across BNPL providers, consumers can quickly become overwhelmed, especially if they’ve lost track of payment due dates.

2. Lack of Credit Reporting - BNPL providers often don’t report positive payment histories to credit bureaus, so responsible use won’t necessarily boost a consumer’s credit score. On top, when people are taking home mortgage, or auto loans then banks are finding it hard to know how much debt the person have in BNPL loans that are not reported to Bureaus.

If payments are missed, some BNPL providers may report delinquencies, negatively affecting credit scores even though positive payments aren’t always reported.

3. Limited Regulation and Consumer Protections - BNPL isn’t subject to the same regulations as traditional credit products, leading to gaps in consumer protections. Some BNPL providers don’t have clear processes for disputing charges, making it hard for consumers to resolve issues like unauthorized purchases.

4. High Late Fees and Penalties - While BNPL is marketed as interest-free, many providers impose significant late fees. Over time, these can add up and even rival or exceed credit card interest rates, trapping some consumers in cycles of debt.

Conclusion

BNPL has redefined how consumers approach short-term credit, providing a user-friendly alternative to traditional credit cards. It has spread across various sectors, from retail to healthcare, offering flexible, transparent payment terms that appeal to a generation of digital-first consumers.

The marginal cost of internet remains negligible, fintech will continue to innovate, pushing the boundaries of consumer finance.

That is a wrap up for now. Your comments, opinions, and corrections are all much welcomed. If you enjoyed this article and think others will too, give this article a like below and share it. Thanks!