Sergio Ibarra
Associate Editor
Loyola University Chicago School of Law, JD 2024 

The 2008 financial collapse occurred when banks began substantially increasing access to debt in the form of adjustable-rate mortgages. These types of mortgages allowed borrowers to take out home loans at an intertest rate that would increase over time. This meant that more borrowers could afford the initial mortgage payments but would end up defaulting on the loans when their adjustable interest rates kicked in. The banks then packaged these high-risk loans together and sold them as securities to mutual funds, investment banks, and pension funds. When most of these high-risk loans defaulted, the market crashed. The collapse occurred in part because the housing market lacked the regulations needed to deter this kind of high-risk lending. The recession that followed cost thousands of jobs, homes, and retirement accounts.

What is Buy Now, Pay later?

Lenders increasing access to debt, an underregulated market, the sale of high-risk loans as securities, and a looming recession are factors appearing again in buy now pay later (BNPL) business models. PayPal Credit, Klarna, Affirm, and Afterpay are the main players in this market. These BNPL firms operate by offering consumers, who shop using their app, the ability to break up the cost of their purchases into multiple payments spread over time. Essentially, these BNPL firms are offering short-term unsecured loans to their consumers. The BNPL model has the psychological effect of making consumers believe that they can afford a purchase they might not otherwise be able to afford, because the initial cost is usually only about 25% of the total. The payments are also spread out over months. The payments on these loans are usually accompanied by 0% interest as long as the consumer repays quickly and on time. These firms are targeting Millennials and Gen Z, who continue to show a preference for eCommerce over traditional brick-and-mortar.

The appeal of making purchases and worrying about them later is not the only thing drawing in Millennials and Gen Z. BNPL firms also forgo the traditional time-consuming application process of credit score checks, income eligibility, and work history when issuing loans. For example, Klarna and Afterpay only require a consumer’s name, address, phone number, and birthday before giving the user access to $1000 of credit. The entire process takes only a few minutes. Low-interest rates, ease of access, and the amount of credit immediately available are all highly appealing to consumers who otherwise may not qualify for short-term loans or credit cards.

How BNPL firms make a profit

Most BNPL firms do not charge interest unless consumers miss payments or extend the time allotted to repay loans. When consumers pay on time, they pay 0% interest on their loans. BNPL firms lose money on these transactions because of the costs of processing these transactions. To make up for these losses, BNPL firms draw on revenue from merchant fees, gains on sales of loans, and servicing income. Merchant fees reflect the price BNLP charges merchants for access to their app, usually 2-3% of the sale. More importantly, every year BNPL firms package a portion of their loans and sells them as securities to investors. The firms are still responsible for servicing these loans and charge a fee for doing this. Firms like Affirm are publicly held, so according to their public disclosures the revenue from securities sales and servicing fees account for 20% of their total revenue. Although data may not be available for all BNPL firms, due to the loss of profits on 0% loans and a lack of other revenue-generators, privately held BNPL firms are likely in a similar position.

Current regulations

The relatively original business model and the recent popularity of BNPL firms in North America has allowed them to escape many of the regulatory demands typically placed on comparable companies, such as credit cards and other loan brokers. The US Consumer Financial Protection Bureau has called for increased regulations, citing the potential for invasions of consumer privacy. In other cases, states like California have taken actions to classify BNPL firms as loan providers, subjecting them to state-wide regulatory standards. However,  there is not a specific federal regulatory framework for dealing with BNPL firms.

Concluding thoughts

There are enough similarities between the 2008 collapse and the current rise of BNPL firms that federal regulators should take affirmative steps to subject BNPL to similar regulations as other loan providers. BNPL firms enable consumers to believe they can afford purchases that probably can’t afford. They are also irresponsibly increasing access to loans by not properly qualifying their borrowers, and then selling portions of these loans as securities to investors.  This is occurring at a time when economists are predicting a recession in 2023. If a recession does occur borrowers will be more likely to prioritize repaying traditional loans and day-to-day expenses before repaying their obligations to BNPL companies.

BNPL companies are already reporting a higher rate of late payments by borrowers. If those borrowers then default on their loans, it will affect the securities sold by BNPL firms in ways similar to the 2008 crisis. When borrowers default on their loans the investors that purchased these loans as securities will not be able to recoup their investment. Federal regulators may not be able to implement fast enough regulations before a recession occurs and borrowers begin defaulting on their loans.