Will 'buy now, pay later' put Generation Z in a debt trap?

Americans are infamously indebted, with ballooning credit card balances stealing headlines as inflation eats into paychecks. But there's a new kid on the finance block.

The so-called "buy now, pay later" (BNPL) industry is taking the United States by storm. The number of Americans who have used the lending model, which is highly popular in Australia, has increased 300% every year since 2018, according to Bloomberg.

BNPL companies like Afterpay, Klarna and Affirm claim that the model is financially inclusive to people who can't access traditional forms of credit.

But consumer advocates argue the model is underregulated and poses risks to consumers.

"In reality, it's a way for consumers to rack up a lot of debt in a little bit of time, unknowingly," said Elyse Hicks, consumer policy counsel at Americans for Financial Reform.

If the sector continues to grow, it could put a generation of younger Americans into a debt trap.

The rise of BNPL in the US

While the sector's various companies may differ slightly, BNPL services allow a consumer to pay for an item or service in four interest-free installments over a period of time, typically two weeks. Already ubiquitous online, BNPL is now also beginning to be introduced in stores.

While BNPL started picking up steam before COVID-19, a pandemic-related shift in consumer spending to e-commerce and retail goods fueled the sector's growth. According to a study by IT services and consulting firm Accenture commissioned by Afterpay, BNPL purchases increased 230% since the beginning of 2020.

Use estimates vary, but similar studies indicate that from one-third to one-half of Americans have used BNPL services. The sector has penetrated younger populations more than any other.

Several tech and financial services companies are also jumping on the bandwagon. In June, Apple became the latest major player to announce its own BNPL service.

Buy (more) now, (can't) pay later

For consumers, companies like Klarna and Affirm often pitch their interest-free, installment-based loan services as liberation from the credit card industry and other predatory lenders.

But users, particularly young ones, are already building up debt. The reasons are both psychological and regulatory.

Consumer advocates emphasize how consumers' ability to purchase products in incremental payments appears to make people buy more — and more than they can afford.

Consumers interpret split payments as more affordable, and as a result, tend to abandon their shopping carts less and purchase more frequently. Indeed, that's why merchants are willing to pay BNPL servicers' 2% to 8% fees, which is more than what credit card companies charge.

According to Hicks, the affordability BNPL services promise is illusory. "It's costing consumers a lot more money than it probably would have if they just used their credit card," she told DW.

Many users are missing payments — and regretting their purchases. According to Credit Karma, almost 40% of BNPL users say they've missed at least one payment.

BNPL services generally don't charge interest like credit cards, but they do charge fees or other penalties when users miss a payment. Late payments may even trigger overdraft fees in a buyer's bank account.

Young people appear most susceptible

Private financial and investing advice company Motley Fool found that almost 50% of young people using BNPL made a late payment or incurred a late fee — the most of any age group.

Unlike credit cards, it can be difficult to track what exactly is owed. If users take out multiple BNPL loans at once, they can quickly get themselves into trouble.

In general, many consumers appear to be confused by BNPL. One survey found about a third of BNPL users don't understand the service well.

Chemareea Biggs is one person who fell into a debt trap after stacking BNPL loans. After losing multiple jobs during the pandemic, she was unable to pay back Affirm's "pay-in-four" loan for plane tickets, triggering a debt spiral.

She told Bloomberg that after missing one payment, the situation went downhill.

Same service, different regulation

Part of the reason consumer debt traps are even possible is that BNPL services are mostly unregulated.

Consumers have numerous protections against traditional lenders, like credit card companies, under the Truth in Lending Act (TILA). But BNPL lenders are able to skirt TILA because the law only covers loans that are split into five payments or more. BNPL stops short at a split of four payments.

Hicks told DW that "a lot of the buy-now-pay-later companies don't want that to be seen as a loan. Because if it is seen as a loan or a line of credit, then it fits one of the regulations."

Skirting TILA means BNPL companies have less legal responsibility to make sure users can pay back the loan. Some services may do mild credit checks for big-ticket items, but for the most part loans are handed out with no questions asked.

While specific BNPL services may ban users until their debt is paid, those consumers are not prevented from taking out loans at other BNPL companies.

BNPL companies present the ease at which consumers can use their products as financial inclusivity for those barred from traditional credit.

Act as credit cards, treat as credit cards

But according to a study from American consumer credit reporting agency TransUnion, BNPL users actually tend to have more credit cards, retail cards, installment loans or other credit products than the "general credit active population."

Meanwhile, another study found that nearly one-fifth of BNPL customers only used the service after maxing out their credit card.

Taylor Roberson, federal policy counsel at consumer advocacy group Center for Responsible Lending, told DW: "One of the most positive aspects of the product has to do with the potential for consumers who pay on time to have that payment history positively recorded on their credit reports. And that's perhaps where the benefits end."

Roberson explained how at present, consumers are not rewarded by credit rating agencies for paying BNPL loans on time, partly because these lenders are not required to report their data like other lenders.

But even when BNPL companies do choose to report their data, users may find that their credit score suffered a hit if they missed a payment.

Roberson and other consumer advocates believe one solution is for BNPL to be regulated by TILA and supervised by the Consumer Financial Protection Bureau (CFPB). Indeed, the CFPB opened an inquiry into the industry late last year, and its findings are expected to inform consumer groups going forward.

"These are fundamentally credit cards in terms of what the statutes and the regulations say. So we think they should be regulated as such," Roberson concluded.