What could quell the boom in 0% installment lending

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On the Urban Outfitters website, shoppers can purchase a six-drawer dresser for four interest-free payments of $212.25, each one equal to a quarter of the item’s $849 price tag.

If all goes as planned, the furniture will be fully paid off in six weeks, which is not too much longer than it will take for the unassembled dresser to be delivered.

Zero-percent interest plans with short repayment schedules are an increasingly popular method of financing everything from cosmetics to apparel, especially among young adults who do not have credit cards. But the products carry risks both for shoppers and lenders, particularly at a time of rising economic distress. They also raise new questions about the regulation of consumer credit in the digital economy.

The company that offers installment financing at urbanoutfitters.com is Afterpay, an Australian firm that has expanded rapidly in the U.S. over the past 18 months. Its thousands of U.S. retail partners also include Anthropologie, Levi’s and Skechers.

Melbourne-based Afterpay reported recently that it had 3.6 million active U.S. customers during the last six months of 2019, up from just 700,000 in the first half of the year. Underlying retail sales in the U.S. that were financed by Afterpay rose by 445% over the same six-month span.

The 6-year-old company has grown so quickly because of a value proposition that has proven enticing to many retailers: In exchange for fees that are higher than what merchants typically pay to accept credit cards, stores can expect a big boost in both purchase sizes and the percentage of shoppers who complete their transactions.

Urban Outfitters is one of Afterpay's many retail partners in the U.S.
Urban Outfitters is one of Afterpay's many retail partners in the U.S.

HSBC noted in a 2018 report that online shoppers who click on an item often abandon their purchases because they decide that the price tag is too high. Financing options from firms such as Afterpay can help to reduce consumers’ cost concerns, the report stated.

Put another way, four payments of $50 can seem more manageable to cash-strapped consumers than a single $200 obligation.

Participating merchants pay Afterpay an average of a little under 4% of the revenue they generate from the sales, according to CEO Anthony Eisen. But Afterpay says that the retailers’ conversion rates increase by roughly 22%, and their average order values increase by 20% to 30%, more than offsetting the higher acceptance costs.

“Our growth has been very viral,” Eisen said in an interview last week.

A regulatory gray area
Afterpay is one of several companies — others include Klarna, Quad Pay and Sezzle — in the nascent consumer finance segment known as “Buy Now, Pay Later.” Their products have fallen into something of a gray area for U.S. financial regulators.

Because Afterpay does not charge interest, and its customers agree to pay off their obligations in just four installments, its product does not appear to fall within the parameters of the Truth in Lending Act, which requires lenders to provide borrowers with information that could enable comparison shopping.

But just because Afterpay’s loans are interest-free does not necessarily mean they are cost-free to the borrower. When an Afterpay customer misses a payment, the company may charge a late fee. Those fees can be as much as $8, according to the company’s U.S. website. Total late fees are capped at 25% of the initial order value.

Eisen, a former investment banker who co-founded Afterpay in 2014, said the company’s product was designed to prevent consumers from falling into a debt trap. Customers who fall behind and owe a late fee cannot use the product again until their outstanding balances are settled.

“Our service is very efficient at weeding out people who shouldn’t be using it,” Eisen said. “Importantly, we don’t seek to make money from late fees. We lose more than we collect. It really is an incentive for customers to pay on time.”

In the second half of last year, Afterpay, which is publicly traded in Australia, derived 15.3% of its total income from late fees, down from 17.6% in the same period a year earlier. A study commissioned by Afterpay that was published early last year found that 93% of the company’s customers do not pay late fees.

Companies that rely substantially on late fees could eventually draw pushback from consumer advocates.

“I don’t think it’s appropriate for late fees to be designed as a revenue source, and as a way of disguising interest charges,” said Lauren Saunders, associate director at the National Consumer Law Center. Saunders made clear that she was speaking in general terms and not about Afterpay specifically.

State regulators are another source of uncertainty for Afterpay and other companies that offer 0% interest financing on retail purchases. A key question is whether states will classify these products as loans, which can trigger more protections for consumers.

In December, the California Department of Business Oversight issued a legal opinion to an unnamed point-of-sale lender, stating that the firm’s product met the legal definition of a loan and rejecting the company’s argument that it did not have to be licensed under the California Financing Law.

The following month, Sezzle received a California lending license, but only after agreeing to pay a fine and refund consumers for loans that it had already made without a license. California officials concluded that Sezzle customers who owe fees after falling behind on their payments could potentially pay annual percentage rates in excess of 600%.

Mark Leyes, a spokesman for the California Department of Business Oversight, said last week that other companies in the rapidly growing industry are still under review.

“We have some disagreement with some of the operators about what does and does not constitute a consumer loan under state law,” he said.

Analysts at the Swiss bank UBS have argued that Afterpay’s share price could decline as a result of looming regulatory risks. “In our view, somewhat paradoxically, the more successful Afterpay is, the more likely it will attract regulatory scrutiny,” the analysts wrote in an October 2019 research note.

Eisen said that Afterpay’s U.S. unit, which added former U.S. Treasury Secretary Lawrence Summers to its advisory board last fall, operates within all federal and state requirements.

An Afterpay spokesperson added, “While we don’t consider ourselves to be traditional credit, we consider and take seriously our responsibility to comply with applicable law.”

Anticipating the next downturn
Sometime in the coming months, Afterpay plans to expand further in the U.S. by enabling merchants to offer its financing plan to customers while they are in stores. The company already offers in-store financing in Australia, where shoppers generate bar codes on their mobile phones and scan them at the cash register.

In-store capability in the U.S. would match a feature introduced last year at Walmart stores by Affirm, a San Francisco-based company that charges interest on its installment loans and does not collect late fees.

“A lot of our major retailers are very keen to launch in-store with us after they’ve seen the success online,” Eisen said.

Scott Galloway, a marketing professor at New York University’s Stern School of Business, has argued that Afterpay and its upstart competitors should be making massive investments in their businesses in order to fend off competition from more established players.

“A lot of our major retailers are very keen to launch in-store with us after they’ve seen the success online,” says Afterpay CEO Anthony Eisen.
“A lot of our major retailers are very keen to launch in-store with us after they’ve seen the success online,” says Afterpay CEO Anthony Eisen.

JPMorgan Chase, Citigroup and American Express all now offer products that allow their U.S. customers to turn their credit cards into products that offer fixed repayment costs. Last year, Visa also introduced technology that enables issuers of Visa-branded cards to offer installment payments.

Another potential threat to Afterpay is an eventual rise in the firm’s loss rates. The Australian company bears 100% of the loss when shoppers fail to repay their loans. So far, those costs have been manageable. Gross losses totaled 1.0% of the firm’s underlying sales volume in the second half of 2019, which was down from 1.2% in the first half of the year.

Still, the odds of a U.S. recession appear to have increased in recent days as the economic damage from the coronavirus outbreak spreads. Consumers who live paycheck to paycheck — including many of the young adults that Afterpay targets — could be particularly challenged during the next downturn.

Afterpay, which reported total debt equivalent to $270 million in U.S. dollars at the end of last year, could also be hurt by a disruption in funding markets. The company has a $200 million receivables warehouse facility with Citigroup and another of the same size with Goldman Sachs.

During his recent interview, Eisen expressed confidence about the durability of Afterpay’s business model.

He said that Afterpay has developed proprietary technology that determines whether to accept or reject a transaction in real time, and that loss rates have decreased as the company has included more data.

Eisen also said that Afterpay customers cannot have outstanding balances of more than $2,000, which means that the company has less exposure to particular customers than credit card issuers typically do. And he noted that about 85% of the firm’s sales volume comes through debit cards, which are linked directly to consumers’ bank accounts, helping to ensure repayment.

In addition, Eisen stated that the short-term duration of Afterpay’s loans gives the company the opportunity to make changes quickly in response to evolving circumstances. “So we feel very good about our model in a climate that might get a little bit tougher,” he said.

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