Background
Innovation in the field of credit products offered by financial institutions and fintech has witnessed tremendous growth recently. Most often, the innovation is a result of functional changes in the structure of traditional credit products. One of the primary reasons behind such innovation is to simplify the shopping experience of the customers and to facilitate the purchase of the products desired by the customers which are often beyond their current purchasing power.
One such innovation is the Buy Now, Pay Later (‘BNPL’). It is a type of credit product provided to customers purchasing goods from a merchant associated with the BNPL provider. Under this type of facility, the customer has the option to pay the purchase price of the product in lump sump at a deferred period of time or in installments, at periodic intervals at no or low-interest. The working mechanics of the BNPL product have been discussed at length in subsequent paragraphs. Though, it is noteworthy that minor functionalities of the product are modified by the merchant according to their requirements. For instance, the Flipkart BNPL does not permit payment of installments at an earlier date. However, Amazon BNPL permits pre-payment of the installments. Thus, the following models only serve as a skeleton of how the product would function.
The BNPL facility is offered to the customer at the end of their purchase journey, i.e at the time of checkout from the merchant’s application. Hence, they are also called point-of-sales financing. The product is gaining momentum- as statistics show, the BNPL market is valued at $90.69 billion in 2020, and is projected to reach $3.98 trillion by 2030, growing at a rate of 45.7% from 2021 to 2030.
Through this article, the author intends to study the BNPL as a payment instrument and different models of the BNPL product that may be adopted by merchants.
Different Types of BNPL Models
As per a report by McKinsey and Company, there are five BNPL models which are adopted by merchants. intending to offer financing solutions to their customers. The models are distinguished on various factors, such as minimum credit scores required to take the credit, the manner in which they function and the credit size they offer. The following diagram depicts the credit size different models provide.
The models are discussed at length hereinbelow: -
Integrated shopping apps
Typically, BNPL facility is offered at the time of checkout by the customer from the merchants’ application. However, this type of BNPL facility can be offered through two platforms-
Firstly, the BNPL payment option is provided to the customer at the time of checkout from the merchant’s application; or
Secondly, the BNPL provider may host multiple merchants on its website. In such a case, the BNPL payment option is available to the customer when he completes purchase from merchant(s) hosted on the website of the BNPL provider.
As we note above, these type of BNPL providers integrate the customers’ shopping experience as well as facilitate the payments of the products shopped by them, and provide an end-to-end solution to the customers. From the customer’s perspective, since they are shopping from the BNPL provider itself, they do not need to visit multiple websites for their different needs. The product works in the following manner:
Once the customer decides to avail the facility and gets through the credit checks, the BNPL provider settles the amount of the product with the merchant. The BNPL provider pays the merchant the price of the product purchased by the customer reduced by the fees charged by the BNPL provider;
Once the account between the merchant and the BNPL provider is settled, the merchant goes out of the picture and the transaction now subsists between the BNPL provider and the customer;
Once the merchant receives the price consideration, the merchant ships the product to the customer as though the customer had directly paid the merchant.
The price of the product is converted into installments to be paid by the customer at pre-determined intervals. Usually, the customer is not charged any interest on the credit facility offered to them. Even if the interest is charged, the rates are usually low. However, it is a common practice to charge default fees in case the customer defaults on payment of these installments;
Now, the customer has to pay the installments to the BNPL provider at pre-determined intervals. The model is explained in the following figure:
Figure 2: Integrated shopping app model of BNPL
As we see from the above, the model works as a two-way integration – merchants provide BNPL option at the time of customer’s checkout and merchants are hosted by the BNPL platforms even if the respective merchants have not provided the BNPL option at their checkout page. The latter facility broadens the scope and usage of the BNPL product of the BNPL provider.
Card-Linked Installments
This type of BNPL model is used for higher value purchases. Under this model, the BNPL companies have partnerships with the credit card companies pursuant to which they facilitate conversion of the entire purchase amount into installments stretching over a tenure of few months (variable as per the amount of the loan).
Unlike credit cards, this model of BNPL offers credit at zero interest rates or minimal interest rates. However, the late fees and other fees are charged to the customer on the basis of the credit card’s policy and the BNPL providers do not have any role in the same;
Once the customer has opted for the BNPL facility, he is notified of the re-payment schedule. Initially, his credit card is charged only with the first installment. However, an amount equivalent to the entire purchase price less the first installment is put on hold and the same is reduced from the entire available credit card limit. In other words, the customer will not have to pay the entire purchase amount in the first billing cycle of the credit card but at the same time, he cannot utilise the credit limit which is put on hold consequent to the purchase.
This benefits all the parties in the transaction – the credit card issuer company and the BNPL provider are not concerned about the creditworthiness of the customer as the entire purchase amount is already put on hold by the credit card company. Upon default by the customer, the proportionate credit limit of the credit card would be reduced and the same shall be charged to the customer. This provides a security against defaults by the customers. For the consumers, they are eligible to obtain credit at minimal costs and no credit checks thereby leading to a hassle-free purchase experience.
Now, as and when the payments are made, restrictions on credit limit gets proportionately reduced and now, the customer is eligible to use the credit limit which was put on hold earlier. The model is explained in the following figure:
Figure 3: Card-linked installments model of BNPL product
Off-Card financing
This type of financing is used in case of seldom purchases of high-ticket size. The functioning of the model is similar to that of the first model, i.e integrated shopping apps model. However, the key difference lies in the credit amount extended by either of the models i.e the credit extended in the latter model is significantly larger when compared to the former one.
Due to this primary difference, we come to the other difference between the two models: since the credit size is larger in case of off-card financing, the tenure of re-payment of credit may also be longer than offered in the integrated shopping apps model. Further, since the credit extended involves a large sum and there is a higher degree of risk involved in the transaction, the BNPL providers are likely to charge interest (at rates lower than regular interest rates) on the credit extended. The model is explained in figure 1 shown hereinabove.
Virtual rent-to-own model
The virtual rent-to-own model (‘VRTO model’) is akin to a leasing model, wherein the lessor (in this case, the BNPL provider) gives on lease to the lessee (the customer) the product desired by the latter.
Initially, the BNPL provider purchases the goods desired by the customers;
When the BNPL provider becomes the owner of the goods, he leases out the said products to the customer;
Once the customer repays the entire amount, the ownership of the asset passes from the BNPL provider to the customer;
Even though both the models – leasing and VRTO model are built on a similar premise, there are some differences between the two, explained as:-
Low cost – The interest rate charged by the BNPL providers is usually lower as compared to the lease rentals paid under the traditional leasing model.
Application – The BNPL facility can be used only with the merchants which have tied up with the BNPL provider. However, while leasing, wider options available when it comes to choosing from various merchants.
Initial payments – In case of leasing, the initial payment consists of security deposit, primarily to ensure that the goods leased out are not damaged or the amount is sufficient to cover any damages whereas in case of BNPL, a down payment as a portion of the entire of the purchase consideration is taken.
Apart from these cosmetic differences, there is a substantial difference between the two concepts and has been discussed in the forthcoming paragraphs.
How is VRTO model different from other financing options?
Financing by way of loan –
A customer may purchase high-value goods by availing of loans from financial institutions. In this case, a sum is sanctioned and disbursed to the customer. The customer then purchases the goods from the sanctioned funds and attains ownership of the goods. Thereafter, the customer repays the loan taken, to the financial institution in installments along with interest on the principal sum borrowed. The goods purchased merely act as a collateral, which can be repossessed in case the customer defaults in payment of dues to the financial institution. However, the ownership of the goods lies with the customer.
In case of pledge of goods as well, though the possession of the goods passes on to the financial institution, the ownership remains with the customer.
However, in case of the VRTO model, the ownership of the goods remains with the BNPL provider and the ownership passes to the customer only when he has paid the full amount of the product along with fees, if any charged by the BNPL provider.
Security by way of mortgage and charge pertains to immovable property. Since the BNPL model primarily revolves around movable property, the former has not been discussed at length in the comparison above.
Leases-
Leases are premised on the principle that the lessee shall return the leased goods after the tenure of the lease. Herein, return of the leased good is an essential feature as the lessee takes the goods for temporary use. By leasing, merely the right to use the asset passes on to the lessee. Similarly, in case of the BNPL model as well, the right to use the asset passes to the customer.
However, the key point of distinction is that the lessee is not obligated to return the goods at the end of the lease tenure. In fact, the model is designed in a manner to facilitate transfer of ownership of the goods from the lessor to the lessee at the end of the lease transfer.
Figure 4: Virtual rent-to-own model of BNPL product
Vertical-focused larger ticket plays
The model primarily focuses on financing high-value purchases. Under this model, the customer is sanctioned a credit limit and he/she is permitted to use the credit limit with any of the partner merchants registered with the BNPL provider. Thereafter, the customer can repay the borrowed amount in installments, as agreed to between the BNPL provider and the customer. This model offers the customer a revolving line of credit, which gets renewed when the customer repays the credit availed by him at the time of a previous purchase. Herein, the issuing bank plays an important role by backing the financial assistance extended by the BNPL provider.
How is this BNPL model different from other financing options?
Financing by way of a credit card
The abovesaid model is akin to the system of credit cards, wherein the user is sanctioned with a credit limit and he can use the card for payments at the time of various purchases. However, the major difference between the two is that while the credit card can be used with any merchant accepting that credit card, the BNPL facility can only be used at stores that have partnered with the BNPL provider. Thus, the former has a wider scope as compared to the latter.
How do BNPL providers earn?
From the above discussion, it is evident that the primary attraction of the BNPL products is lower cost of finance as compared to the traditional modes of finance. However, the imperative question is, how do the BNPL providers earn when they offer finance at such a low cost?
The BNPL model primarily generates revenue from the merchants, rather than charging the customers. The BNPL providers charge a percentage of product price from the merchant, which have been paid for, using the BNPL model. The merchants too, readily accept the model despite incurring such additional costs as it leads to increase in the cart conversion and lowers the card abandonment by customers, who usually do not have any source of finance to pay for the products. In this manner, the BNPL model facilitates sales of the merchants.
Further, the BNPL providers also earn by late fees charged from the customers in case the latter defaults on making the payment as per the re-payment schedule agreed between the two.
In many cases, the BNPL providers also charge interest from their customers where the amount involved in the purchase is high or the tenure of the credit is long.
Closing Thoughts
The BNPL model is gaining momentum as it offers a hassle-free experience to the customers, when compared to the traditional credit models. However, it is yet to fair in the Indian context. Though some models of the BNPL product have a wide reach in India, some models like financing for healthcare services or heavy purchases is yet to make its entry as traditional finances like credit cards and personal loans still dominate the arena. However, analysing the success of the initial entrants in the BNPL market, the way forward is likely to be smooth.
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