Buy now, pay later: Understand it before you use it

For generations, retailers have offered customers the opportunity to make a purchase today and pay over future installments. Who can forget layaway departments, or the promise of "three easy payments of $19.99"? Call it the "buy now, pay later" (or BNPL) philosophy.

During the pandemic, when people were stuck at home and e-commerce sales surged, consumers turned to new BNPL technologies to make their purchases more accessible.

Buy now, pay later offers a good news, bad news scenario, depending on your financial habits. If you typically spend within your budget and are committed to making on-time payments, BNPL might be a useful strategy. But if you're the kind of person who sometimes misses a payment, it could really hurt your finances.

Whether it makes sense for you, it's hard to deny that BNPL is here to stay. In fact, more than 20% of consumers with a credit record have used BNPL to finance a purchase according to the Consumer Financial Protection Bureau (CFPB) Opens in a New Window.‍ ‍ ^{See note 1}

Read on to learn more about BNPL so you'll be prepared the next time you make a purchase.

How does BNPL work?

Traditional layaway plans had their heyday after the Great Depression and continued in popularity until credit cards gained steam in the 1980s. Unlike layaway, where the retailer holds your purchase until you've finished paying for it, BNPL lets you take your purchase at the time of the transaction.

Today’s “buy now, pay later” options — like buy now, pay later loans; pay-over-time apps; installment payment apps; pay-later sites; and payment plan apps — are a little different from department store layaway programs, but the concept is basically the same: You pay for your purchase in a series of installments — usually four even payments, with a payment made every two weeks — with zero-interest financing.

Zero-interest financing is a reason many BNPL shoppers use the technology. It was reported that 59% of users cite avoiding interest charges as their reason for turning to BNPL, according to the Federal Reserve Opens in a New Window.‍ ‍ ^{See note 1}

Let's say you've found a new $200 coat from your favorite online retailer. When you pay, you see a BNPL payment option that allows you to pay $50 today, then another $50 payment every two weeks for six more weeks. As long as you make your payments on time, you don't pay interest. But if you miss a payment before the interest-free period ends, you face big late fees and interest charges.

Some of the most familiar BNPL apps include Klarna, Affirm, Afterpay and Sezzle. Each varies slightly when it comes to some of the details. Affirm, for example, doesn't charge late fees, but you aren't allowed to use the service if you have outstanding charges. Afterpay and Klarna charge late fees, but they're capped. And some, claiming they don't charge interest, actually only offer "interest-free" periods.

Additionally, most BNPL companies don't run hard credit checks before allowing you to open an account. Some run a "soft pull" as part of the approvals process, but that won't impact your credit score.

BNPL versus credit cards

When consumers use BNPL technology, they're likely to spend more. And with average order values being higher, retailers are willing to pay the BNPL company a small percentage of the transaction value — just like they do with credit card transactions.

Unlike credit cards, which can generally be used almost everywhere, most retailers partner with just one BNPL company. For that reason, consumers who like to use BNPL often have accounts with multiple BNPL providers.

Multiple accounts with different BNPL providers mean there’s more to keep track of in terms of total balance, payment amounts and due dates. And while BNPL providers offer automatic payments, ensuring you don’t load up on debt and overdraw your bank account or miss a payment is a real concern.

Worse still, some consumers enter into a chain of borrowing and turn to credit cards to service their BNPL debts. About 63% of users open simultaneous BNPL loans at some point during the year, according to the CFPB.

If you're drawn to this technology because it allows you to make interest-free purchases, that can really backfire when you're forced to use high-interest-rate credit cards to make the payments.

How can BNPL impact your credit?

In the event that you default on your payments, most BNPL companies will close your account and demand that you pay your remaining balance immediately. If you don't, they'll send your debt to collections, which is bad news for your credit rating.

There's potentially another downside to BNPL vs. credit cards: In the early days of BNPL, making on-time payments wouldn't help your credit. That's because BNPL providers didn't report account history to your credit report.

However, credit agencies have reconsidered their policies on recognizing BNPL in credit reports. Equifax® was the first to declare that it would implement a new "business industry code" for BNPL — in 2022, they formalized the process for inclusion on traditional consumer credit reports Opens in a New Window.‍ ‍ ^{See note 1}

Balance the rewards with the risks.

BNPL isn't necessarily a bad option. Taken at face value, no-interest loans can be useful. If you have plenty of money in your bank account to cover your purchases or you're spending within your budget, it's possible that BNPL could be a responsible way to save money. This is especially true if it allows you to defer paying all at once with no interest or fees, so you can use the "lender's" money in the short term, instead of tying up your own.

But if BNPL is used as a crutch to pay for products you can't afford, it's just enabling overspending.

Affirm, Afterpay, Klarna, PayPal and Zip started collecting information on the risks and benefits of BNPL credit under orders from the Consumer Financial Protection Bureau, or CFPB Opens in a New Window.‍ ‍ ^{See note 1} The CFPB was concerned that:

• Consumers’ ease in getting these BNPL loans is causing them to spend more than anticipated.
• BNPL providers are able to use the technology to skirt current consumer protection laws, such as providing certain disclosures or dispute resolution protections.
• BNPL providers are harvesting data from consumers, using their customers’ payment history to create closed-loop shopping apps and push specific brands and products.

At the end of the day, options like BNPL make it easier to overconsume.

As simple as it sounds, spending less than you earn goes against society’s narrative, which is to consume, consume, consume. Even when you’re spending within your budget, it’s important to remember that buy now, pay later apps are very new and consumers are taking a risk when they rely blindly on them to make purchases.