Buy now-pay later providers, with their no-interest, short-duration loans that grew popular during the COVID-19 pandemic, could see their business models stressed in the uncertain economic times ahead, the credit ratings agency Fitch Ratings said in a recent report.

Higher inflation, rising interest rates, the potential risk of a recession and more competition could all squeeze finances at these firms, Fitch analysts said in the July 28 research note. It’s an open question as to how well they will navigate the changing economic climate, said Michael Taiano, a senior director on the North American bank team at Fitch.

Rising interest rates will make it more costly for these businesses to get loans to fund their operations, just as they’re grappling with increased competition from a proliferation of BNPL providers. 

In addition, the typical lower-income consumers who use these services are more vulnerable to higher inflation and the risks presented by a recession, the Fitch analysts said in the note. It’s an open question how well these firms might navigate the changing economic climate, said Michael Taiano, senior director on the North American bank team at Fitch.

“These products still resonate with the consumer… but the ‘pay in four’ model really wasn’t used pre-pandemic,” he said in an interview this month.

BNPL’s “pay in four” model, which divides payments for a product or service into four equal, no-interest installments, has been popular with lower-income consumers who may have limited credit options. The smaller amounts may be easier for buyers to handle while the bi-weekly or monthly payment amounts often match with their paycheck schedules.

Merchants offer the payment option because it may result in new or higher sales from users. Still, the merchants must pay higher than standard payment fees in order offer BNPL services. While credit card interchange fees for merchants are about 2.25% per transaction, it’s more like 4% on a BNPL transaction.

Last year, U.S. BNPL volume was $43 billion, equivalent to just a fraction of the $4.6 trillion in U.S. credit-card purchase volume, according to the report.

To fund their growth, BNPL companies funneled money into front-end infrastructure and securing new merchant relationships early on, instead of trying to become profitable, Taiano said.

Now, as interest rates rise, the cost of financing the pay-in-four loans increases for the BNPL providers, Taiano said. If they’re unable to get merchants to pay more for transactions, “your margins are going to get squeezed,” he explained. BNPL providers that rely more heavily on wholesale funding, including securitizations and loan sales, will likely experience a more rapid increase in their cost of funding, the Fitch report said.

Recession risks are a second headwind for these firms, especially if their typical users are affected by job losses that lead to repayment delinquencies. During the pandemic, consumers tapped government stimulus benefits to make payments, but with savings from that aid likely gone for this cohort, they may be more vulnerable to defaulting on debts if the economy weakens.

The Federal Reserve Bank of New York said on Aug. 2 that household debt increased in the second quarter and is higher than in the pre-pandemic period.

BNPL users tend to carry more debt than consumers in the general population, with roughly 41% and 27% of BNPL applicants having subprime or near-prime credit profiles, respectively, compared to 12% and 13%, respectively, in the general population, Fitch said, citing data from credit reporting bureau Equifax. Part of the reason is that the BNPL group is likely comprised of younger shoppers, Fitch added.

Three of the biggest BNPL companies have already flagged problems because of the changing economic landscape, Fitch noted. In its first quarter report, Klarna said it tightened its lending standards and cut staff, while Affirm and Afterpay reported significant increases in delinquencies over the past year and also raised their allowance coverage ratios.

The BNPL providers can see delinquencies occur quickly and can adjust swiftly by shutting off customers’ buying privileges, Taiano said.

That’s different from a credit-card user with a line of credit who suddenly falls into financial trouble. “You can continue to draw down on that (credit line),” he said. “At a certain point, (card issuers) will probably look to shut down or cut that line, but it could take much longer and you’re still exposed for that full amount.”

BNPL also exists as a form of “shadow banking,” given these payment plans aren’t considered loans because the platforms don’t charge interest, the analysts said.

There’s also inconsistency in reporting consumer data to credit bureaus, Taiano said, which opens risks to other lenders who might issue credit to delinquent customers. “You wouldn’t necessarily know they have a bunch of buy now-pay later, smaller dollar loans outstanding,” he said. “So you’re in a way a bit blind to that.”

Reporting to the credit bureaus is changing in the wake of BNPL. Experian this year said it planned to open a BNPL bureau so providers of such financing, fintechs and other point-of-sale lenders can track and share payment data tied to these transactions.

Regulators are starting to look at these platforms, too, with the Consumer Financial Protection Bureau asking the largest firms for information on BNPL practices last year and how they may affect consumers.

At the same time, competition is heating up for these platforms. Apple recently launched Apple Pay Later, which could be a potential game-changer, given Apple’s iPhone user base, merchant acceptance and existing payment infrastructure, Taiano said.

The big card network company Visa has also announced BNPL services, with Mastercard angling to do the same.

If margins being squeezed by higher interest rates and higher default rates prompt BNPL providers to ask merchants to pay more for the installment services, they may be in a tough spot. They aren’t likely to extract much more from merchants “because there’s so many alternatives out there,” he said.