Since the start of the pandemic and the first round of lockdowns, e-commerce predictably took off, as consumers could no longer access most physical stores and turned to online shopping en masse. Around the same time, another trend began to emerge: “Buy Now, Pay Later” (BNPL) services, offering shoppers ways to break down their purchases into small installments, quickly gained momentum, as more and more digital marketplaces and retailers partnered up with BNPL providers and included this payment option in their checkout process.

The idea behind BNPL is really nothing new. It’s similar to traditional layaway plans or installment financing options retailers have always offered to consumers, allowing them to purchase an item even if they don’t have all of the cash on hand. What’s different about this modern, digital reincarnation of this concept is that it is now being widely used for small, everyday purchases, not just for expensive appliances, electronics and other big-ticket items.

In fact, this payment option is now offered by retailers like Target, Walmart and Amazon, and it is even being used for daily grocery shopping. Another notable difference is that BNPL services are usually promoted as “interest free” and they are a lot easier to access. As a recent Fitch report highlighted, “the underwriting process is typically very fast and based on "soft credit checks rather than more thorough vetting required in other forms of credit.”

While the convenience of this new payment option is undeniable, it also entails some serious risks that most consumers fail to take into account. For one thing, the ease of use and the frictionless checkout experience simply doesn’t give buyers enough time to consider their purchasing decisions and it encourages them to spend more, even when that spending is beyond their means. It is also a lot easier to misjudge what they can objectively afford, as the total amount of their purchases can seem lower when it is split up into smaller chunks. Tracking their spending becomes more challenging too, as payments are spaced out and automatically withdrawn from their accounts over weeks or even months.

Even more worryingly, many consumers fail to realize what they’re really signing up for. The two-click process feels a lot more like any other online shopping experience, instead of the short-term loan application it actually is. And this is where the real danger lies for the majority of buyers who do not stop to read the terms and conditions. Most BNPL services might indeed be “interest free”, however the conditions that apply to this offering are very strict. Late payment penalties and collection fees vary between providers, but they can accumulate very quickly. Consumers who miss a payment can easily find themselves on the hook for exorbitant amounts even for small purchases and fall in a debt spiral reminiscent of the vicious circle of payday loans.

The lack of credit checks significantly compounds the risks of the BNPL trend. In Australia, the birthplace of some of the most successful BNPL providers, the consequences of the mass adoption of this payment option are already becoming clear. As Kirsty Robson, a financial counsellor with Australia’s National Debt Helpline pointed out, "People we speak to haven't been able to afford rent because they've had too many buy now pay later payments come out of their account, and they haven't been able to afford to buy food. They've been buying their groceries with buy now pay later and then getting stuck in that kind of trap where they use the product for their living essentials and then pay it down and then have to use it for their living essentials again.”

While the trend started in Europe and Australia, it quickly spread to the US, with BNPL companies like Klarna, Affirm and Afterpay attracting huge investor interest and online payment giants like PayPal rushing to get in on the action and roll out their own products. According to a recent survey by LendingTree, one third of consumers have already used this option to finance their purchases and among those, almost two-thirds have used it five or more times.

And yet, estimating the actual risk levels in this new lending market is extremely challenging. Given the different versions of the service and the lack of regulation in this budding industry, measuring the size of the market itself is very difficult, while the absence of uniform reporting standards makes it almost impossible to form a clear idea about overall debt performance. According to the aforementioned Fitch survey, “31% of U.S. respondents have made a late payment or incurred a late fee using BNPL methods”, a figure that should raise concerns given the fact that most BNPL providers "have not set aside large provisions for losses and report minimal bad debt."

Today, the BNPL boom is being hailed by many investors and market analysts as “the future of millennial finance” and the momentum behind the burgeoning industry seems unstoppable. The skyrocketing adoption rates and the potential for global expansion certainly support this bullish view. However, given the very real risks that are embedded in this corner of the lending market, not just to consumers but to providers too, the widespread enthusiasm could prove premature, and investors could soon regret jumping on the BNPL bandwagon.

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