New Economic Realities   //   January 26, 2024

As phantom debt concerns grow, BNPL platforms are touting new underwriting practices

As buy now, pay later plans swell in popularity, the startup companies behind the services are increasingly investing in their underwriting processes or teaming up with legacy financial institutions to safeguard against overspending.

While the Consumer Financial Protection Bureau has signaled interested in regulating the area, right now it’s up to the companies to do as much — or as little — lending per customer as they see fit. But as usage of the platforms hit record highs, there’s more backlash against the role they could play in “phantom debt,” or spending that’s not allocated on a credit report.

In response, BNPL companies are investing in AI-powered predictive technology and teaming up with legacy providers to safeguard the underwriting process. Larry Diamond, CEO at Zip, said being able to rely on modern tools is partly why BNPL is popular among younger customers, who may not have lengthy credit histories.

“We are continuously evaluating daily performance, and that’s the beauty about these products. The data comes back so quickly, you get such a good read on what’s the quality of the new customer coming in,” he said. “Your ability to adapt in real time with your machine learning models is vastly superior to traditional consumer finance.“

The short-term loan products, which began taking off in the Untied States at the beginning of the pandemic lockdowns, are gaining steam as the companies expand into new vertical likes health care and travel, and offer different products like longer-term, fixed-rate installment plans. Adobe Analytics found that BNPL sales hit an all-time high of $940 million on Cyber Monday in 2023, a 42.5% increase from the year before. Access to the product is also expanding. Both Zip and Affirm will be piloted on Google Pay shopping services this quarter, and Apple Pay Later is now available to all customers.

But with that growth comes more potential for misuse and saddling shoppers with extra debt. The average U.S. shopper already carries about $6,000 in credit debt, a 10-year high, not accounting for the BNPL loans that aren’t reported to credit bureaus. While companies like Klarna, Affirm, Afterpay and Zip will cut off someone from getting any future loans if they miss a payment — and they point to default rates at less than 1% — some customers can get in over their head by making too many loans across providers that others can’t see.

In response, the BNPL providers are continually tightening up their underwriting practices — and calling out how their practices are eliminating risk. Klarna, for instance, said its credit losses as a percent of GMV dropped by 56% “due to continuous improvements in underwriting precision and accuracy ensuring Klarna continues to make the right lending decisions for consumers.”

For its part, Zip is “heavily investing” in its risk and decisioning capabilities this year, Diamond said, with the hope of increasing approval rates. That includes investing in its “proprietary decisioning engine,” and a recent addition of  transactional bank data. Rolled out in the fourth quarter of 2023, this allows Zip to look directly into the customers’ bank account to understand their financial picture. Diamond said this is especially helpful for younger customers or those without a meaningful credit history.

“We never want to turn away a customer that we shouldn’t have to turn away,” he said. “But equally, we turn away a lot of customers who aren’t ready, or aren’t eligible for credit.”

Ways to improve underwriting

Soft credit checks, which allow a bank or loan institute to look at a someone’s credit history without it affecting the applicants store, are frequently used to gauge the creditworthiness of a BNPL customer. But an emerging trend in the space is BNPL companies teaming up with banks to help provide short-term installment products, or the banks themselves offer BNPL-style plans. Citi, American Express and Chase offer variations of products that allow people to borrow against their credit, or create a post-purchase payment plan.

Nandan Sheth, managing director and CEO of SplitIt, a white-label BNPL provider, said one of the company’s key priorities in 2024 is launching an installment service that works with banks and issuers. The model could be less risky than a standard BNPL plan because the financial institutions already have a relationship with the customer and know their profile. 

“They’re defining new revenue from an existing relationship,” he said. “It gives them the ability to fight against fintech in BNPL space but it absolutely offsets,  if not reduces, our risk significantly.”

Sheth said this could be safer for the consumer because they wouldn’t be able to engage in “plan stacking” or getting multiple loans from other providers.

“For every single purchase they make, they’re going to be leveraging credit that they already have earned with that bank. And now they’ll have the opportunity to use it for installments,” he said. “I think it’s a more responsible way to do installment payments at scale.”

At Affirm, factors like credit score, prior repayment performance, credit utilization and transaction history are taken into account at every request for a loan. An Affirm spokesperson told Modern Retail, “we use machine learning technology calibrated on many data points and our more than 10 years of operations to learn from previous decisions and continuously refine our underwriting.”

Equipifi, which allows debit card companies to offer BNPL plans, works with about 30 banks and credit unions to date. Founder Bryce Deeney said the compay well-positioned to work on installment plans because it knows the customer’s history. Traditional lenders, he said, are accustomed to underwriting consumers for a large sum with a one-time decision, typically based on the FICO score. The BNPL model, he said, takes the consistency of cash flow into account, looking at how much someone can afford. 

“I think the more that BNPL matures and financial institutions and other lenders understand that, the more they’re going to grasp that, ‘Hey, this actually is a safer way to underwrite consumer,’” he said.

Another tactic in this area is the idea of “open banking,” or the ability for third-parties to obtain banking data. A Klarna spokesperson told Modern Retial that’s one data source it can use in some cases, “which allows customers to securely share income and spending data from their bank accounts.”

The Consumer Financial Protection Bureau is working on a draft proposal around regulating open banking, aiming to provide more consistent financial data from service to service and ensure the systems are secure. And it’s also signaled that it could pass other regulations in the space, noting concerns about how BNPL products can be more popular among younger or more financially vulnerable customers.

While it’s unclear if those rules will drop this year, Deeney said it’s likely the agency is taking its time.

“They don’t want to stifle innovation,” he said. “And they also understand that tens of millions of Americans like this form of credit, so they have to be cautious in how they respond.”