Buy Now Pay Later

Executive Summary

'Buy Now, Pay Later' (BNPL) is a system of deferred payments that provides consumers with the option to purchase goods or services immediately and pay for them over a set period through installments. This innovative financial model has gained immense popularity, offering a convenient alternative to traditional payment methods such as credit cards and loans. By integrating directly at the point of sale, typically through online platforms or apps, BNPL schemes facilitate instant gratification for consumers while allowing them to manage their cash flow more effectively.

The Meteoric Rise of BNPL

The BNPL sector has experienced rapid growth, not just in the United States but globally. Originally popularized by "Pay-in-4" plans, which divide payments into four equal parts over four weeks without requiring a comprehensive credit check, the BNPL landscape has evolved to include a variety of credit forms. These range from installment loans and credit lines to virtual rent-to-own models and vertical-specific options catering to larger purchases. This expansion reflects the adaptability of BNPL systems to diverse consumer needs and market segments. BNPL providers have further enhanced their offerings by introducing expanded services for both merchants and customers, including comprehensive shopping apps that consolidate various shopping and payment functions into a single platform. This move towards creating a holistic shopping ecosystem signifies the industry's shift from a simple payment method to a comprehensive retail solution.

Revenue Models and Market Dynamics

BNPL companies primarily earn revenue through merchant fees, typically ranging from 2% to 8% of the transaction value. While some BNPL schemes, like Pay-in-4, avoid interest charges and rely on late fees for missed payments, others, such as installment loans, may include interest fees. Venture capital backing emphasizes rapid market share acquisition over immediate profitability for many BNPL firms. Initially, BNPL's rapid growth was driven by partnerships with major merchants and expanding the customer base, particularly among younger demographics. However, as the market matures and large merchants establish BNPL partnerships, growth strategies must adapt. The entry of traditional financial institutions into the BNPL space adds further competition, demanding innovation and differentiation from BNPL providers

Buy Now Pay Later Programs – Revenue Model

Buy Now, Pay Later in the Last 20 Years: A Digital Revolution

Over the last two decades, the 'Buy Now, Pay Later' (BNPL) industry has undergone a significant transformation, largely driven by advancements in technology and changes in consumer behavior. This period has seen the transition from traditional credit systems to sophisticated digital platforms, reshaping how consumers approach installment payments and access credit.

The 2000s: E-Commerce Growth and Financial Innovation

As the internet became more accessible and secure, the 2000s witnessed exponential growth in e-commerce. This period also saw significant financial innovations, with companies exploring new ways to extend credit to consumers online. Early forms of BNPL began to emerge, allowing consumers to defer payments or split purchases into manageable installments. These services were initially offered by retailers themselves or through partnerships with financial institutions, aiming to make larger purchases more accessible and boost sales.

The 2010s: The Rise of Fintech and BNPL Platforms

The fintech boom of the 2010s was a game-changer for BNPL. Startups like Klarna, Afterpay, and Affirm, leveraging technology and big data, began to offer streamlined BNPL services directly integrated into the online checkout process. These platforms differentiated themselves from traditional credit by offering simple, transparent terms, minimal fees, and often, zero interest. The convenience and flexibility of these services resonated with consumers, particularly millennials and Gen Z, who were cautious of traditional credit cards and debt.

The 2020s: Mainstream Adoption and Expansion

The BNPL model has seen mainstream adoption in the 2020s, accelerated by the COVID-19 pandemic, which led to a surge in online shopping. BNPL has expanded beyond its initial niche in e-commerce to encompass a wide range of industries, including travel, healthcare, and even in-store purchases. The concept has also attracted the attention of major financial players and tech companies, some of whom have launched their own BNPL services or integrated existing ones into their platforms. Looking ahead, regulation, innovation, and global expansion are key themes as BNPL becomes an integral part of the consumer credit landscape. Regulatory bodies are taking a closer look to ensure consumer protection and financial stability. The industry is also at the forefront of innovation, with companies exploring new features like loyalty programs, personalized shopping experiences, and integration with broader financial ecosystems. Additionally, the global expansion of BNPL services is opening up new markets and opportunities for growth.

BNPL Business Mode

BNPL programs present a contemporary variation on traditional installment payment schemes, delivering unique advantages to both merchants and consumers. Although these programs are built on a consistent foundation, the BNPL sector is distinguished by a wide array of payment plans, each offering a distinct perspective on consumer welfare. Among the companies that classify themselves as BNPL, there exists a diverse range of payment options, prioritizing various aspects of consumer well-being. The 'Pay-in-4' plans and installment loans stand out as some of the most prevalent BNPL arrangements, yet there are numerous other models worth mentioning.

Revenue Model (1) Pay-in-4:

The 'Pay-in-4' or pay in 4 interest-free payments over 6 weeks scheme stands as the hallmark of the Buy Now, Pay Later (BNPL) industry, primarily catering to smaller purchases. This model, structured as a four-week loan, distributes the payment into four equal installments, commencing at the point of sale and continuing bi-weekly. Notably, this approach generally exempts interest, relying instead on late fees for missed payments, although certain providers like PayPal have eliminated both late fees and interest, setting a potential trend for heightened industry competitiveness. Revenue generation in the Pay-in-4 model predominantly comes from merchant fees, typically constituting a percentage of the transaction value. These fees frequently surpass traditional credit card interchange fees, at times reaching up to eight percent of the product's price. This cost is justified by merchants for the tangible benefits BNPL brings, such as heightened sales volumes and broader consumer outreach. Insights from Affirm's promotional content highlight BNPL's capacity to amplify average basket sizes and enhance conversion rates at the point of sale. Furthermore, an emerging trend among Pay-in-4 BNPL services is the development of integrated shopping applications. These platforms entice consumers with Pay-in-4 options, simultaneously serving as promotional channels for associated merchants. The popularity of these apps is on a notable rise, with leading BNPL applications (Affirm, Afterpay, Klarna, and Zip) witnessing over a 20% increase in downloads in 2021, totaling over three million, as reported by Bank of America. This surge underscores the growing consumer preference for flexible payment solutions and the integral role of BNPL services in modern e-commerce ecosystems.

Let's consider an example to illustrate the revenue and expense dynamics within the 'Pay-in-4' BNPL model, using a transaction for a product priced at $200.

Example Transaction:

1. Product Price: $200
2. BNPL Option: Pay-in-4

Payment Structure:

1. The customer opts for the Pay-in-4 plan at the point of sale.
2. The total amount is divided into four equal installments of $50 each.
3. Payments are scheduled bi-weekly, starting from the purchase date.

Revenue from Merchant Fees:

1. Assuming the BNPL provider charges a merchant fee of 6% on the transaction value.
2. Merchant Fee: 6% of $200 = $12

Economic Rationale for the Merchant:

Despite the $12 fee, the merchant benefits from the BNPL arrangement by attracting customers who prefer or need to spread out their payments, potentially increasing sales volume and reaching a wider customer base. The BNPL option might also lead to larger average purchases (basket sizes), as consumers feel more comfortable committing to higher-priced items with manageable installment plans. For example, if the BNPL option increases the merchant's average sale from $150 to $200, the incremental revenue ($50) far exceeds the BNPL fee ($12), making the arrangement economically viable for the merchant.

Integrated Shopping Apps:

The BNPL provider promotes the merchant's products on its integrated shopping app, further increasing the merchant's visibility and potential sales.

The surge in app downloads indicates a growing consumer base actively looking for BNPL options, broadening the reach for associated merchants.

Assume that the integration with the shopping app leads to a 10% increase in sales for the merchant, translating to additional revenue that more than offsets the BNPL fees.

Revenue Model (2) Medium-Ticket Installment Loan:

The 'Medium-Ticket Installment Loan' program extends the versatility of Buy Now, Pay Later (BNPL) services to encompass more substantial purchases, offering consumers a viable alternative for financing larger-ticket items. This expansion reflects the adaptability of BNPL systems to cater to a wider range of consumer needs, beyond just smaller, immediate purchases.

Overview of Medium-Ticket Installment Loans:

Target Purchases: These loans are tailored for mid-sized purchases, such as appliances, electronics, or furniture, bridging the gap between small everyday items and large-scale investments.

Payment Structure: The loans are structured with monthly payments spread over six to twelve months, providing a manageable repayment schedule that aligns with the consumer's cash flow.

Interest and Fees: Given the higher value of the purchases, these loans typically include interest charges to compensate for the extended credit risk. Occasionally, merchant fees may also apply, contributing to the revenue stream for BNPL providers.

Consumer Insights:

Surprisingly, about 80% of consumers who opt for these installment loans possess a credit card, indicating a strategic preference for installment-based financing over traditional credit card debt, possibly due to the clearer repayment timeline and, in some cases, more favorable interest rates.

Evolving Market Dynamics:

Off-Card Financing Solutions: These installment loans are often categorized as off-card financing, distinguishing them from traditional credit card purchases by offering a dedicated repayment plan for specific purchases. Card-Linked Installment Loans: There is a noticeable trend towards card-linked installment offerings, particularly in markets like Asia and Latin America. This approach integrates the BNPL installment model directly with credit cards, allowing consumers to convert specific credit card purchases into installment loans post-purchase.

Competition with Credit Cards: In the competitive landscape of U.S. consumer finance, credit card companies are increasingly adopting BNPL features, introducing post-purchase installment plans to retain their market share. A McKinsey report suggests that integrating such installment options is becoming crucial for credit card issuers to remain competitive, enabling them to offer more flexible repayment solutions and potentially attract a broader consumer base.

The Bigger Picture:

The Medium-Ticket Installment Loan program within the BNPL sector signifies a strategic shift towards offering more nuanced financial products that cater to diverse consumer purchasing behaviors. This approach not only broadens the appeal of BNPL services but also challenges traditional credit providers to innovate and adapt. As BNPL firms continue to evolve, offering a spectrum of financing solutions from Pay-in-4 plans to medium-ticket installment loans, they redefine the landscape of consumer credit, emphasizing flexibility, consumer choice, and tailored financial products. The ongoing integration of BNPL features into traditional credit card offerings highlights the growing influence of BNPL models on the broader financial services industry, suggesting a future where consumer finance is increasingly customizable, user-friendly, and integrated into the shopping experience.

Let's create a hypothetical scenario to illustrate the revenue and expense dynamics of a 'Medium-Ticket Installment Loan' within the BNPL model, focusing on a consumer purchasing a $1,000 appliance.

Example Transaction:

1. Product Price: $1,000
2. BNPL Option: Medium-Ticket Installment Loan

Loan Terms:

1. The consumer opts for a 12-month installment plan for the appliance.
2. Assuming an interest rate of 10% applied to the loan.

Payment Breakdown:

1. Total Interest Over 12 Months: 10% of $1,000 = $100
2. Total Repayment Amount: $1,000 (principal) + $100 (interest) = $1,100
3. Monthly Installment: $1,100 / 12 months = $91.67

Revenue from Merchant Fees:

If the BNPL provider charges the merchant a 4% fee on the transaction value.

1. Merchant Fee: 4% of $1,000 = $40

Economic Rationale for the Merchant:

The merchant incurs a $40 fee for utilizing the BNPL service, which is offset by the benefit of making a $1,000 sale that might not have occurred without the BNPL option. The BNPL service can lead to increased sales by attracting customers who prefer to spread out the cost of large purchases. For example, if offering BNPL options leads to a 20% increase in sales of such appliances, the additional revenue generated would significantly outweigh the cost of BNPL fees.

Revenue for the BNPL Provider:

1. Interest Revenue: $100 collected from the consumer
2. Merchant Fee Revenue: $40 collected from the merchant.
3. Total Revenue: $140 for facilitating the $1,000 transaction.

The BNPL provider generates $140 in revenue from a single $1,000 transaction through a combination of interest payments and merchant fees. The consumer benefits from the flexibility of spreading a large purchase over 12 months, with a clear understanding of the interest costs involved. Meanwhile, the merchant benefits from increased sales volume and the ability to cater to customers who prefer installment payment options.

Revenue Model (4) Virtual Rent-to-Own:

The Virtual Rent-to-Own model within the Buy Now, Pay Later (BNPL) framework offers a unique approach to consumer finance, particularly catering to a demographic that might not have access to traditional credit due to subprime credit scores. In this model, consumers essentially 'rent' an item, making installment payments until the total cost of the item is covered, at which point ownership transfers from the retailer or financier to the consumer.

Key Features of Virtual Rent-to-Own:

Target Audience: This model predominantly serves consumers with lower credit scores, offering them a pathway to acquire goods they might otherwise be unable to afford upfront.

High APRs: To mitigate the risk associated with lending to subprime consumers, Virtual Rent-to-Own agreements often come with higher Annual Percentage Rates (APRs), making it crucial for consumers to understand the total cost of ownership over the rental period.

Eligible Goods: The items available under this model are usually those that can be repossessed if payments are not made, such as mattresses, furniture, electronics, and appliances. These items are chosen based on their value retention over time and the feasibility of repossession.

Economic Implications for Consumers:
While the Virtual Rent-to-Own model provides immediate access to necessary or desired goods, the financial terms can lead to paying significantly more than the item's retail value due to high APRs. Consumers should carefully consider the total cost of ownership under these agreements and explore other financing options that might offer more favorable terms.

Benefits for Retailers and Financiers:
Retailers and BNPL providers offering Virtual Rent-to-Own plans can tap into a broader market by accommodating consumers who are typically underserved by traditional credit markets. This inclusivity can lead to increased sales and customer loyalty, although it also requires robust risk management strategies to address the higher likelihood of default associated with subprime lending.

Expansion and Innovation in BNPL Services:

The Virtual Rent-to-Own model exemplifies the diversity and adaptability of BNPL services, responding to the varied financial needs and circumstances of consumers. As BNPL providers continue to innovate and expand their offerings, they contribute to a more inclusive financial ecosystem, empowering consumers with more choices and control over their purchasing decisions.

Example Transaction:

Let's illustrate the revenue and cost structure of a Virtual Rent-to-Own model within the BNPL framework using a numerical example. In this scenario, a consumer enters into a Virtual Rent-to-Own agreement to acquire a $500 appliance.

Transaction Details:

1. Product Retail Price: $500
2. Agreement Duration: 12 months
3. APR (Annual Percentage Rate): 20%

Payment Breakdown:

1. Monthly Payment Calculation: Assuming a simple interest model for ease of calculation, the total interest over the year would be 20% of $500 = $100.
2. Total Repayment Amount: Principal ($500) + Interest ($100) = $600 over 12 months.
3. Monthly Installment: $600 / 12 months = $50 per month.

Revenue for BNPL Provider:

Interest Revenue: The $100 interest charged over the term of the agreement constitutes direct revenue for the BNPL provider Merchant Fees: If the BNPL provider charges the merchant a fee of 5% on the transaction, that would be 5% of $500 = $25 as additional revenue.

Virtual Rent-to-Own Mechanism

Total Cost of Ownership: The consumer pays a total of $600 for a $500 appliance, making it essential for consumers to consider whether the convenience of immediate access outweighs the additional cost.

1. Initial Status: At the beginning of the agreement, the consumer does not own the appliance but has the right to use it while making payments.
2. Monthly Installments: The consumer agrees to pay $50 every month for 12 months, totaling $600. This series of payments is what constitutes the 'rent' portion of the arrangement.
3. Transfer of Ownership: After the final installment is paid, the ownership the appliance transfers from the BNPL provider or retailer to the consumer, completing the 'rent-to-own' process.

In this model, the key features that align with a typical Virtual Rent-to-Own structure include:

1. Deferred Ownership: The consumer only becomes the owner of the appliance after all payments are completed.
2. High APR: Reflective of the high-interest rates often seen in Rent-to-Own agreements, the example includes a 20% APR applied to the cost of the appliance.
3. Repossession Risk: While not explicitly mentioned, in a Virtual Rent-to-Own arrangement, there is usually an implicit risk that the item could be repossessed if the consumer fails to make the payments, similar to a physical rent-to-own store policy.

This example demonstrates how the BNPL provider generates revenue from both interest payments and merchant fees, amounting to $125 ($100 from interest and $25 from merchant fees). This revenue model compensates for the risks and operational costs associated with offering financing to subprime consumers. For consumers, while this model offers immediate access to necessary goods, it comes with a premium in the form of higher total payment compared to the retail price, highlighting the importance of informed financial decision-making.

Revenue Model (3) Deferred Credit Line:

The 'Deferred Credit Line' model enhances the Buy Now, Pay Later (BNPL) ecosystem by blending the ease of BNPL services with the features of conventional credit systems. It offers a sophisticated financial solution designed for consumers who wish to make significant purchases without the immediate imposition of interest charges, assuming they comply with the set repayment terms. Under these payment plans, interest is suspended for purchases exceeding a specific amount over an allotted period. Should the consumer settle the full amount by the end of this deferral period, no interest is incurred. However, if there's any outstanding balance, interest is then applied to the entire original purchase sum, not merely the residual amount.

Overview of Deferred Credit Line:

Interest Waiver: The hallmark of this model is the initial waiver of interest on purchases that meet or exceed a predetermined threshold, offering a grace period during which consumers can pay off their balance without accruing interest.

Deferral Period: This period typically spans several months to a year, giving consumers ample time to manage their finances and settle their debt.

Interest Charges: If the consumer fails to clear the balance within the deferral period, interest is retroactively applied to the entire original purchase amount, not just the remaining balance. PayPal uses this model for their credit service.

Example Transaction:

Let's consider a hypothetical scenario where a consumer purchases a $2,000 television using a BNPL Deferred Credit Line with a 12-month deferral period and an interest rate of 20% applicable post-deferral.

1. Product Price: $2,000
2. Deferral Period: 12 months
3. Post-Deferral Interest Rate: 20%

If Paid Within Deferral Period:

1. The consumer pays off the total amount within 12 months.
2. Total Paid: $2,000
3. Interest: $0

If Not Paid Within Deferral Period:

1. The consumer has $500 remaining after the deferral period.
2. Interest is applied to the entire purchase amount ($2,000), not just the unpaid balance ($500).
3. Retroactive Interest: 20% of $2,000 = $400

Total Paid: $2,000 (original amount) + $400 (interest) = $2,400

Economic Dynamics for BNPL Providers:

Revenue Streams: The BNPL provider may earn revenue through initial setup fees, merchant fees for offering the service, and interest accrued from balances not paid within the deferral period. Risk Management: Providers must carefully assess consumer creditworthiness and set appropriate terms to mitigate the risk of non-payment.

Impact on Merchants and Consumers:

Merchants: Like other BNPL models, deferred credit lines can boost sales by making expensive items more accessible to consumers. Merchants benefit from the increased purchasing power of their customers, albeit at the cost of BNPL service fees. Consumers: This model offers consumers the flexibility to manage large purchases without immediate financial strain. However, the potential retroactive interest charges require careful financial planning and discipline to avoid unexpected costs. In the BNPL Deferred Credit Line model, providers have developed various strategies to ensure profitability, even in scenarios where all consumers pay on time. One of the primary ways BNPL companies can make money, aside from collecting interest on unpaid balances post-deferral period, is through charging fees to merchants.

Additional Revenue Streams:

Setup and Monthly Fees: Some BNPL providers may charge merchants setup fees for integrating the BNPL service into their payment systems, as well as ongoing monthly or annual fees for the service's continued use.

Cross-Promotion Fees: BNPL services may also offer promotional opportunities to merchants, such as featured placement in BNPL apps or marketing campaigns, which can be another source of revenue.

BNPL companies can also leverage their customer base to offer additional financial products or services, such as personal loans or credit building tools, creating more opportunities for revenue generation beyond the initial BNPL transaction.

Even if all consumers were to pay on time, avoiding any interest charges, BNPL providers can still maintain profitability through merchant fees, which constitute a significant portion of their revenue model. This diversified approach to revenue ensures that BNPL services can be sustainable and profitable, supporting their growth and the continued offering of flexible payment options to consumers.

BNPL Providers

While there are dozens of BNPL firms in the market, Affirm, Afterpay, and Klarna are considered the top performing BNPL companies, reporting the highest purchase volume in 2020 (see Figure 2). PayPal is also a top performer in the BNPL space, though it started as a digital payment platform and has expanded into the BNPL space in recent years.

Below is a list of the some BNPL providers:

1. Affirm: Partners with top retailers and offers personalized financing options with transparent terms
2. Tamara: Partners with top retailers to offer flexible, interest-free installment plans with clear terms.
3. Afterpay: Allows consumers to make purchases and pay for them in four interest-free installments.
4. Klarna: Offers various payment plans, including Pay in 4 and Pay in 30 days.
5. PayPal Credit: Provides a reusable credit line for purchases at millions of online stores that accept PayPal.
6. Sezzle: Focuses on financial empowerment by offering interest-free installment plans.
7. Quadpay (part of Zip): Allows consumers to split their purchase into four equal, interest-free installments.
8. Bread: Offers straightforward installment loans for online purchases, with clear terms and conditions.
9. Splitit: Utilizes consumers' existing credit, allowing them to split purchases into monthly payment.
10. Perpay: Offers a unique model where consumers make payments through paycheck deductions.
11. FuturePay: Allows customers to shop online without a credit card and pay later in flexible installments
12. ViaBill: Provides transparent, interest-free monthly payment options without requiring a credit check
13. Acima: Offers a lease-to-own financing option for consumers, applicable to a wide range of products.
14. Uplift: Focuses on travel, allowing consumers to pay for their trips over time with simple, fixed installments.
15. Zebit: Offers a marketplace with a BNPL option.
16. ChargeAfter: Provides a multi-lender BNPL platform, giving consumers personalized financing.
17. Four: Offers a simple and straightforward BNPL option, splitting purchases into four payments.
18. Credova: Caters to outdoor recreation, providing financing solutions that include BNPL options
19. Snap Finance: Offers lease-to-own and financing options for consumers.
20. PayTomorrow: Provides financing options for all credit levels.
21. LendFirm: Offers a BNPL solution that allows consumers to make purchases with flexible payment plans.
22. PayPossible: Connects consumers with multiple financing and BNPL options at checkout.
23. LendFirm: Offers a BNPL solution that allows consumers to make purchases with flexible payment plans.
24. Zibby: Offers a lease-to-own payment option for online shopping, focusing on consumers with low credit.
25. EasyPay Finance: Provides consumer financing solutions for auto repairs, furniture, pets, and more.
26. American First Finance: Offers a variety of financing solutions including BNPL.
27. Koalafi: Provides fast and easy financing solutions with a focus on the furniture and appliance sectors.
28. Tempoe: Provides no-credit-required shopping options with flexible lease terms.
29. City Furniture Credit Card: Offers special financing deals on furniture purchases.

Credit card issuers and payment networks are increasingly entering the BNPL market to compete with established firms, either by partnering with BNPLs, acquiring a BNPL, or offering their own BNPL product.

Revenue Model (5) Large-Ticket Installment Loan:

This model is meticulously crafted to accommodate the acquisition of expensive goods or services, such as healthcare procedures, home renovations, or luxury items, by allowing consumers to spread the cost over a series of manageable payments. Banks are expected to target this space in the next few years to acquire high-credit customers. They also leverage this model to cross-sell mortgage refinancing or other banking services.

Characteristics of Large-Ticket Installment Loans:

Specialized Providers: Typically, BNPL providers specializing in specific categories like healthcare, home improvement, or high-end electronics offer these installment loans, tailoring their services to the unique needs and payment capabilities of consumers in these sectors.

Extended Repayment Terms: Given the higher purchase values, these loans often feature longer repayment periods, which can range from a few months to several years, depending on the purchase size and consumer's payment capacity.

Credit Considerations: This BNPL model tends to cater to consumers with good to excellent credit scores, reflecting the significant financial commitment involved. Providers conduct thorough credit assessments to mitigate the risk of defaults on high-value loans.

Strategic Interest from Banks:

Attracting High-Credit Customers: Traditional banks and financial institutions are increasingly interested in this segment of the BNPL market. By offering large-ticket installment loans, banks can attract and retain customers who demonstrate high financial reliability and creditworthiness.

Cross-Selling Opportunities: For banks, the relationships established through large-ticket BNPL loans open avenues for cross-selling other financial products, such as mortgage refinancing, personal loans, or premium credit cards. This not only enhances customer retention but also increases the lifetime value of each customer to the bank.

Example Scenario:

To illustrate, let's consider a consumer opting for a $20,000 home renovation project through a Large-Ticket Installment Loan:

1. Loan Amount: $20,000
2. APR: 6% (assuming the consumer has a good credit score)
3. Repayment Period: 5 years (60 months)

The consumer would make monthly payments of approximately $387, culminating in a total repayment of $23,220 over the loan term. This setup benefits the consumer by making a substantial home improvement project financially manageable, while the BNPL provider or bank earns interest revenue over the loan duration.

Conclusion:

The Large-Ticket Installment Loan model underscores the adaptability and expansiveness of BNPL services, catering to a diverse range of consumer needs and purchase scales. For category specialists and banks, this model not only facilitates significant sales but also strengthens customer relationships by providing financial solutions that align with consumers' aspirations and financial realities. As the BNPL landscape continues to evolve, the integration of large-ticket installment loans is set to redefine the boundaries of consumer finance, offering a blend of accessibility, flexibility, and strategic financial planning.

While these models constitute the major types of BNPL at the moment, this list is not exhaustive, and new models that are attractive to both consumers and merchants are likely to emerge as the industry evolves. One practice that will remain crucial for BNPL business models is integration into the consumer shopping experience.

Cost Structure

Exploring the intricacies of the cost structure within the Buy Now, Pay Later (BNPL) ecosystem unveils a multifaceted landscape that underpins the operations of both providers and consumers. Delving into the nuanced interplay of costs, credit risk, and profitability metrics provides crucial insights into how BNPL firms navigate the dynamic financial landscape to deliver sustainable and competitive services. As BNPL continues to reshape the retail and financial industries, a deeper understanding of its cost dynamics becomes paramount, shaping the strategies of providers and influencing the choices of consumers. Through adept management of costs and risk factors, BNPL providers can not only ensure their financial viability but also enhance the value proposition for their stakeholders, fostering a symbiotic relationship between service providers and consumers in the evolving world of retail finance.

Cost of Funds:

To finance consumer purchases, BNPL providers typically rely on external funding sources, such as warehouse debt providers, which offer credit facilities based on a borrowing base. This borrowing base is often determined by factors like the value of the consumer loans in the portfolio. The interest rate on these credit facilities is commonly tied to a benchmark rate, such as the Secured Overnight Financing Rate (SOFR), plus a margin reflecting the credit risk and market conditions.

BNPL providers incur borrowing expenses from financial institutions to access these credit facilities, covering costs like interest payments and any associated fees. By accurately assessing the cost of funds and managing borrowing costs effectively, BNPL providers can ensure the sustainability of their operations while offering competitive services to consumers. Efficient cost management in this area is essential for maintaining profitability and financial stability within the BNPL industry.

Let's consider a hypothetical scenario where a BNPL provider obtains a credit facility from a warehouse debt provider to finance consumer purchases. The credit facility has a borrowing base of $100 million, meaning the BNPL provider can borrow up to this amount based on the value of the consumer loans in its portfolio.

Now, let's assume that the interest rate on this credit facility is tied to the Secured Overnight Financing Rate (SOFR), which is currently 5%, plus a margin of 2%. This brings the total interest rate to 7%.

If the BNPL provider fully utilizes the credit facility of $100 million, the annual borrowing expense would be calculated as follows: Annual Borrowing Expense = Borrowed Amount × Interest Rate Annual Borrowing Expense = $100,000,000 × 7% = $7,000,000 So, the BNPL provider would incur an annual borrowing expense of $7,000,000 to finance consumer purchases through the credit facility.

Customer Acquisition:

Acquiring new customers entails significant expenses for BNPL providers, encompassing marketing initiatives, referral programs, and incentives designed to attract and onboard customers, thereby contributing to the customer acquisition cost.

Let's provide a numerical example for customer acquisition cost: Suppose a BNPL provider invests $1,000,000 in various marketing channels, referral programs, and incentives over a specific period, aiming to acquire new customers. Additionally, let's assume that these efforts result in acquiring 100,000 new customers during that period.

To calculate the customer acquisition cost: Customer Acquisition Cost = Total Marketing Expenses / Number of New Customers Substituting the values: Customer Acquisition Cost = $1,000,000 / 100,000 = $10 per customer So, in this example, the BNPL provider's customer acquisition cost would be $10 per new customer acquired

Servicing:

Once customers are onboarded, BNPL providers incur costs related to servicing their accounts. These costs include customer support, account management, and backend operations essential for payment processing and transaction management.

Suppose a BNPL provider spends $500,000 annually on customer support staff salaries, technology infrastructure for account management, and backend operations such as payment processing and transaction management. Now, let's assume that this expenditure is necessary to service a total of 100,000 customer accounts throughout the year.

To calculate the servicing cost per customer account: Servicing Cost per Customer = Total Servicing Expenses / Number of Customer Accounts

Substituting the values: Servicing Cost per Customer = $500,000 / 100,000 = $5 per customer account

Therefore, in this scenario, the annual servicing cost per customer account would amount to $5.

Credit Risk:

Credit risk represents the potential loss of interest income if customers pay off their balances before the scheduled due date. BNPL providers must effectively assess and manage this risk to mitigate potential revenue losses. High rates of consumer loan defaults present a significant challenge to the profitability of BNPL services. Some market professionals have theorized that the BNPL market targets what are known as 'invisible primes' — consumers with low or nonexistent FICO scores who may not qualify for traditional credit but still pose a low risk of nonpayment. However, Equifax research suggests that most BNPL users do not fit this definition: nearly 70 percent of BNPL users have less-than-prime credit scores, compared to just a quarter of the general credit population. Equifax data also indicates that BNPL borrowers resemble the overall credit population in terms of the size of their credit file; they are merely using BNPL as an alternative or supplement to other forms of credit, such as credit cards. The same study found that BNPL users tend to have significantly higher credit utilization rates than the general credit population.

A 2021 survey revealed that nearly 40 percent of U.S. BNPL users admit to falling behind on their payments at least once. Other surveys indicate that less than half of BNPL applicants were 'very confident' they could pay off their loans in full without missing a payment, and a recent Morning Consult survey found that one in five U.S. adults who took out a BNPL loan in January 2022 missed a payment. Beyond late payments, some BNPL users are displaying other signs of financial stress. For instance, in January 2022, one in three BNPL users had overdrafted their bank or credit union accounts. It is unclear whether BNPL payments caused these overdrafts, but several BNPL firms offer automated debit payments from checking accounts, which could result in overdraft or nonsufficient funds fees. Thus, while BNPL offerings may help consumers purchase goods and services without incurring credit card debt or paying interest, they could still lead to negative financial outcomes if payments are not met. Looking ahead, consumer financial stress may increase in the coming months and years due to high inflation and the end of pandemic-era support measures.

Early signs are already evident: according to the Census Bureau, the percentage of Americans struggling to afford household expenses has steadily risen since late summer 2021 and now stands at 34.4 percent as of May 2022.

Expected Loss (EL) or Current Expected Credit Loss (CECL):

EL = Probability of Default (PD) * Loss Given Default (LGD) * Exposure at Default (EAD)

These key credit risk metrics enable BNPL providers to evaluate the likelihood of customers defaulting on payments, the potential loss in the event of default, and the total exposure at default. Managing credit risk is paramount for maintaining financial stability.

Let's illustrate a numerical example:

Suppose a BNPL provider has issued a total of 200,000 loans to customers, each with an average outstanding balance of $500 = 200,000 * $500 = $100,000,000

Let's assume that based on historical data and credit analysis, the BNPL provider determines that the average probability of default for its loan portfolio is 3%.

Probability of Default (PD): = Portfolio Balance * Probability of Default = $100,000,000* 0.03 = $3,000,000

Loss Given Default (LGD):

The BNPL provider estimates that in the event of default, it will be able to recover 50% of the balance so LGD=1-Recover Rate = 50%

Exposure at Default (EAD):

The exposure at default represents the total amount of outstanding balances at the time of default.
Assume 50% of the loan balance.

Expected Loss (EL) or Current Expected Credit Loss (CECL):

In this example, the BNPL provider expects to incur an expected credit loss of $$750,000 over the life of the portfolio due to defaulting loans. These credit risk metrics allow the provider to assess and manage the potential losses associated with default, enabling them to maintain financial stability and make informed lending decisions.

Enhancing Analytics and Loan Pricing

As the BNPL sector continues to grow, the transition to profitability and sustainability will be paramount. Vector's ML Platform offers BNPL companies a suite of tools designed to enhance credit analytics, optimize loan pricing, streamline operations, and support strategic decision-making. By leveraging Vector's capabilities, BNPL firms can better navigate the challenges of a competitive market, ensuring their long-term success and satisfying the demands of investors and consumers alike.

Enhancing Analytics and Loan Pricing BNPL companies, often fueled by venture capital, have prioritized rapid market expansion over immediate profitability. However, as the market evolves and investors seek returns, these firms must refine their credit analytics and loan pricing strategies. Vector's ML Platform, powered by AI algorithms, offers advanced loan-level analytics, enabling BNPL firms to make informed decisions regarding credit risk, loan terms, and pricing models. This can lead to more sustainable lending practices and improved financial performance.

Optimizing Asset-Liability Management The dynamic nature of the BNPL market requires firms to maintain a delicate balance between assets and liabilities. Vector's tool can aid in asset-liability management by providing a comprehensive view of a company's financial standing. By automating and enhancing the accuracy of financial models, BNPL companies can better predict cash flows related to their loan portfolios, incorporating assumptions about default rates, recovery, and prepayment. This precision helps in optimizing the balance sheet and ensuring liquidity, crucial for sustaining operations and fostering growth.

Strategic Decision-Making for Profitability In the face of stiff competition, especially from legacy financial institutions with deep pockets and vast networks, BNPL firms must make strategic decisions to ensure their long-term viability. Vector's profitability modeling software aids in this by enabling firms to quantify revenues and expenses accurately and model their impact on profitability. This insight allows BNPL companies to identify areas for cost reduction, optimize pricing strategies, and explore new revenue streams, ultimately leading to improved profitability.