Buy now, Pay Later has been one of the fastest-growing segments in consumer finance over the last few years. In 2021 alone, it generated over 141 billion in transaction value worldwide. Klarna, Afterpay, and Affirm all became multi-billion dollar companies, attracting millions of users and thousands of merchants.
But behind it, all was a flawed business model, a business model built on low-interest rates and a complete lack of regulation, a business model that claimed to be helping consumers on the one hand and increasing profits for retailers on the other. I mean, how can that even be possible? How can you make claims that your business is good for consumers when at the same time you’re telling retailers that your service will lead to bigger orders, higher conversions, and more frequent shoppers?
Are The Purchases Better For Consumers?
How can a system that actively helps people justify bigger discretionary purchases ever be better for consumers? But look, I get it. Being able to split one-off birthday gifts or grocery bills into four interest-free payments takes real pressure off struggling families.
The problem is that while 25% of people did say that they used it for groceries, 63.5% said they used it for clothing. Suddenly that $200 T-shirt became way easier to justify because it’ll only cost 50 bucks a day and I can wear it out of the store by now. You would’ve heard of the big players, Klarna, Afterpay, Affirm, and Zip, but have you ever wondered how they actually make their money? I mean, they literally say that if you split your bill across four payments, you’ll never pay them any interest. Well, they’re trading off the fact that you’ll be more likely to make a purchase if you use them in-store.
Their whole business model revolves around the idea that Buy Now Pay later, means you’ll spend more every time you make a purchase. The company, for example, after pay takes a 4% cut of the purchase price from the retailer. The promise of you spending more and more often is why retailers are willing to take the hit after pay claims are, on average order values increase by 18%, so a 4% commission is justifiable to retailers.
And while there are other ways that these companies make money like charging late fees when people don’t pay, that 4% commission is the backbone of their business. So on the surface, the business model made sense, and with the boom of e-commerce during the pandemic, companies like Klarna, Afterpay, and Affirm saw massive spikes in their valuation.
I mean, in 2020, Afterpay was the best-performing company on the Australian stock market, growing its shares by over 300%. If you’d invested $10,000 when they went public back in 2016, by 2020, it would’ve been worth over 400 grand. And so, the business model looked good, but just because it looked good doesn’t mean it actually worked.
If you look up any buy now, pay later company today, you’ll see that its share price is absolutely tanked. I mean, these companies don’t even make a profit. Affirm, is not profitable. Klarna, not profitable. Afterpay, well, it was quiet, but it still hasn’t turned a profit. To emphasize how bad it’s been, here are a few headlines. Client evaluation drops by 85% from over 45 billion to just seven. Affirm cuts 19% of its workforce. Zip achieved record revenue. Yes. Still loses 240 million. Open pay collapses going into administration. Latitudepay is too close, it’s a complete mess.
During the pandemic, it was all about rapid growth and grabbing market share. So I guess back then, a lack of profitability was almost expected. But now, why can’t any of these companies make it work? Well, as I said, on the surface level, the business model looks good, but if you dig a little deeper, it all starts with one wine.
How They Actually Make Their Money
Firstly, let’s look at how they actually make their money, and we’ll do that by looking closer at Afterpay.
Remember when I said that they charge late fees? If you didn’t pay on time? Well completely forget about that because according to their 2021 financials, those late fees only made up 10% of the company’s revenue. It’s 90% where the problem lies. Afterpay charges merchants between four and 6% for every sale made through them. Sounds pretty good, right? I mean, I’d love to scrape an easy 4% off the top. Wrong!
Think about what actually happens when you make that purchase. When you make a purchase, you pay a 25% deposit, and Afterpay covers the rest, that means that they have to come up with 150 out of your $200 t-shirt. But where does that one 50 actually come from?
Well, not from Afterpay’s pocket. They need to borrow that money too. And of course, the bank they borrowed it from wants to earn some interest. After that, it is easy! They just wait six weeks until you pay off the loan. But what if you don’t? Well, some people don’t. And so those bad debts further cut into their profits.
So a big-picture overview of the business model is their commission. Less the bank’s interest, the less the amount people will never pay back. But here’s where it gets interesting. Remember how I said these businesses, boom, during the pandemic? Well, that wasn’t just because of a rise in online shopping. The pandemic led to record-low interest rates, which meant the cost of borrowing money was next to nothing.
It was essentially a perfect storm for businesses that relied on borrowing money to lend to shoppers, but here’s what they didn’t see. Low-interest rates lead to an increase in the supply of money. Which leads to inflation.
And how do governments combat inflation? Raising interest rates, meant that the cost of borrowing that one 50 for your t-shirt just got a whole lot more expensive. And this meant with every rate rise, their margins started to shrink. More rate rises are needed to bring down inflation, but you have to think about what else happens when interest rates rise.
Well, people’s mortgages become a whole lot more expensive, which means families have less money. And while that might have actually led to more people turning to buy now, pay later options rather than traditional credit cards, it also meant people were more likely to never pay back their loans. A complete shift in the economy meant their whole business model was being squeezed.
Bad debts and interest payments are increasing while the commission they make on each sale stays the exact same, but it keeps getting worse. Remember when I said people mainly use Buy Now Pay Later for discretionary items like clothing? Well, when interest rates rise and people have less money, they’re the first things to go.
Affirm’s founder and CEO, Max Levon said that “Everything changed in mid-2022” and that “Rate rises have dampened consumer spending and increased the firm’s cost of borrowing dramatically”. So not only was there margin on each sale being squeezed, but the number of sales they were doing decreased. But even with all of that, they were still making a slight margin.
So why weren’t they making any profit? Well, out of that slight margin comes every other expense like salaries, rent, and IT costs. But just because they couldn’t make a profit doesn’t mean the model couldn’t be profitable or that there wasn’t a demand for buy now, pay later. I mean, people like the concept, people want to buy now, pay later, they just don’t really care who provides the service, and that’s when the big players entered the market.
Who Stands The Benefit
Apple, PayPal, and the banks are huge companies with cheaper access to funds and platforms already being used by the masses, but that wasn’t their only advantage. While there is money to be made with buy now, pay later, these large institutions. Aren’t reliant on this one model working? If the model isn’t the most profitable but introduces young people to debt, then they stand to gain in the future by converting them to other services like credit cards and home loans.
But that’s not all. Regulators are currently breathing down the necks of any company offering Buy Now, Pay Later. Average people are being offered thousands of dollars in loans without any kind of government regulation. I mean, if it were credit cards, you’d absolutely have to go through a lengthy process.
And so buy now, pay later is essentially a lending loophole, but the loophole is about to close. Regulators from all over are taking action. And who stands the benefit? Well, it’s the company’s already used to regulation. The companies with massive amounts of data on their customers and the companies that aren’t just reliant on one single buy now, pay later business model.
It’s the big institutional banks, and so it seems like the Buy Now Pay Later Gold Rush is over, but we’ll have to wait and see.