How 'Buy now, pay later' can drive poor decision-making

By: Olena Halkowicz
Editor | Financial Markets

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The lustre of credit alternatives is difficult to ignore, and for good reason. The alternatives boast affordability and convenience and come with the promise that your most liquid asset will remain liquid. The newest and shiniest form of lending comes in the shape of ‘Buy now, pay later,’ which allows the consumer to break the upfront cost of a purchase into four equal payments. However, in doing so, the platform also encourages reckless spending and the careless purchase of liabilities.

Alternative Credit’s Profit Puppy

The concept is built on the thesis that younger consumers distrust traditional credit, but still want to borrow money to buy goods. In this context, ‘Buy now, pay later’ (BNPL) behaves as a short-term loan without the accompanying high interest. An argument can be made that at this intersection of consumers and credit facilities exists an opportunity to create an immense profit. By luring the consumer into a semblance of financial security, the consumer is willing to spend more than they could potentially afford in the near future. This grants BNPL firms such as Afterpay or Klarna the capacity to collect a significant late fee.

Nonetheless, the emergence of alternative credit facilities suggests that the financial industry is undergoing changes. This shift from standard credit facilities to flexible payment options may be indicative of the current economic state, one that relies on flexible lending and bite-sized repayments.

Encouraging Instability

With a service such as BNPL, an Afterpay or a Klarna covers the entirety of the purchase for the retailer upfront. The customer is then tasked with the responsibility to pay an instalment over the course of a few months. Profits are generated mainly from merchant fees and late fees collected from customers. Merchant fees are charged to retailers, who pay this premium to BNPL firms hoping to increase sales per customer and conversion rates. Furthermore, flexible payment options help brands reach new customer segments, who previously may not have been able to afford shopping with them.

The question that remains to be answered is whether these lookalike credit facilities really do encourage financial stability, or whether they simply cause an uptick in debt. While BNPL service providers often brand themselves as “agents that give consumers more control over their finances,” there is a weighty risk that the opposite may be true. Simplicity and ease of use are at the forefront of the BNPL strategy, and with opaque late fees, it can be easy for a consumer to spend more than they budgeted. Furthermore, the majority of BNPL solutions are focused on non-essential markets such as fashion and luxury, where impulse buying is a prominent occurrence.

The Psychology of Impulse Buying

Now, what are the driving forces behind impulse purchase decisions? Unsurprisingly, a major factor is price. A study found that 85.4% of consumers list price as a deciding factor for impulse buys, which makes ‘Buy now, pay later’ solutions a dangerous skewing mechanism. Instead of considering the entirety of the cost, the consumer fixates on what must be spent today, thus justifying their decision to impulse buy. Each payment is seen as a manageable amount, one that may even be considered negligible.

Impulse buying behaviour relates to positive emotions and feelings. This initial association of positive sentiment with the act of purchasing will encourage further spending, perhaps beyond an individual’s financial means. The consequence of this is a cycle of endless debt, characterized by the accumulation of minute lump sums. A consumer who had once utilized the service as a tool for finding financial independence has now been led astray to a path of financial insecurity.

A study published by the University of Bath, ‘The Psychology of Impulse Buying’ analyzes the action from different angles in consumer, economic, social and clinical psychology. One of these perspectives is called “The Limited Information Process,” which argues that consumer decisions often violate normative decision making. As a fundamental principle, normative decision making considers all the relevant information in arriving at preferences and choices.

However, due to an information overload and computational complexities which are often involved in normative models, consumers typically engage in much simpler decision-making processes. These processes are often fueled by heuristics. One such model is called Simon’s satisficing heuristic, which claims that alternatives are considered one at a time in the order they occur and are compared to a base level. In this model, the first alternative that meets the outlined criteria is chosen.

In the context of impulse shopping, this model explains why a consumer may be more likely to purchase an item when given the option to finance the cost over a few months. The upfront financial commitment is lower, thus allowing the product to meet the predetermined criterion. Similar to Simon’s satisficing heuristic, most other impulsive choices are driven by simple cognitive processes. What this means for alternative credit facilities is that they have an opportunity to frame the cost as a lesser amount, thus catapulting the value of the item for the consumer. This prompts them to buy impulsively, all under the guise that they are making a sound economic choice.

The Bottom Line

The critics will call it a short-term loan, whereas the skeptics prefer to use the term ‘impending liability.’ Yet another group, the optimists, will refer to the service as an asset or a tool for newfound financial freedom. Regardless of outlook, one can agree that these alternative credit facilities have found an intersection that allows for significant profit margins, sometimes at the expense of the consumer.