‘Buy now, pay later’ is booming. But companies are facing pressure to change.

This holiday season, merchants are poised to use "buy now, pay later" like never before.

Not just a hot new payments or ecommerce feature, it's also a key marketing feature to drive more sales for merchants. The growth has been quick. Consumers are expected to make $100 billion in "buy now, pay later" purchases in 2021, up from $24 billion in 2020, and could increase up to 15 times its current volume by 2025.

An indication of the flux in this new market is that there isn't even agreement about whether "buy now, pay later" purchases are in fact loans. Companies and merchants tout them as convenience features or payment plans, but more regulators and consumer advocates view them as loans that should have the same protections as credit cards or other forms of consumer credit.

Consumers' views matter, too. Right now, many shoppers see "buy now, pay later" as different from traditional credit cards. But that halo could wear off if more have bad experiences with pay-later plans.

There's no disputing the momentum behind "buy now, pay later." Beyond the pure "buy now, pay later" providers like Affirm, Klarna and Afterpay, traditional retailers like Macy's, Target and Walmart are all pushing their own "buy now, pay later" offerings — with the hopes of seeing fewer abandoned shopping carts and bigger baskets.

The companies promote "buy now, pay later" as a better alternative to credit card debt because of lower fees, low or no interest and more transparency. And many consumers, especially younger ones, have moved away from credit cards to avoid getting into debt.

But while "buy now, pay later" can offer benefits compared to credit cards, there are lurking issues that could present challenges to the companies this holiday shopping season.

Consumer confusion

In complaints to the Consumer Financial Protection Bureau, consumers have said that they've had problems with purchases, either because they couldn't make a return or get a refund, or got charged with fees they didn't understand.

Consumers also do not always understand the risks of these products, said Rachel Gittleman, financial services outreach manager at Consumer Federation of America.

"These products are credit and carry the same consequences for defaulting as other types of loans," she wrote in a letter to the House Financial Services Committee.

This kind of confusion can lead to consumers falling behind on payments. In a recent study by Credit Karma, one-third of consumers who used "buy now, pay later" products had fallen behind on one or more payments, and 72% of them said their credit score dropped.

In its September quarter, Affirm's delinquencies over 30 days were about 2.6%, ticking up considerably from the overall fiscal year where they were 1% as the company has sought to open up to a broader range of consumers. Affirm has said that it underwrites each transaction individually using data beyond credit scores, rather than extending a line of credit, to ensure consumers can repay.

Afterpay's net transaction loss as a percentage of overall sales was 0.6% for its year ending in June. Afterpay says 95% of transactions do not incur a late fee and close to one-third of customers make the majority of payments early. To ensure people don't get too far into debt, Afterpay suspends consumers from its system if they are late for a payment.

"Even when people do pay the installments, there's likely a higher number of people who are also at the same time racking up credit card debt," said Melody Brue, principal analyst at Moor Insights & Strategy. "It's sort of ironic that some of these 'buy now, pay later' options are meant to be for people not tapping into credit, but they actually are."

If consumers rack up debt or complaints rise, the companies could lose customers — or money, if the loans don't get paid back. This could undermine one of the big claims for "buy now, pay later": that it's cheaper, easier and better for consumers' credit than a credit card.

The regulatory hammer

Right now, "buy now, pay later" is not regulated in the way that credit cards are. That means there are no standards for disclosures on fees, amounts owed, credit reporting and payments. Even the due date of a "buy now, pay later" payment is not as clear as a credit card with a consistent payment date.

"Right now, one of the biggest issues is that they're operating pretty much largely outside of the regulatory system and outside of federal and state oversight for a variety of different reasons," Gittleman said.

That could change as regulators rein them in.

The U.K. and Australia, where "buy now, pay later" has taken off even faster than in the U.S., have placed these products under a regulatory regime. In the U.K., the Financial Conduct Authority in February said "buy now, pay later" would come under its rules after finding that consumers thought the products carried the same "rights and protections" as regulated forms of credit. The Australian Finance Industry Association created a code of conduct for "buy now, pay later" after a Senate inquiry.

In the U.S., "buy now, pay later" services are covered under the Dodd-Frank Act's protections for deceptive or abusive lending practices, which are enforced by the Consumer Financial Protection Bureau. The CFPB has issued a warning to consumers on "buy now, pay later," and has already brought a case against one company offering income-share agreements, a possible indication of broader intentions on consumer credit.

But "buy now, pay later" often isn't covered by the federal Truth in Lending Act, which requires disclosure of terms and cost of services, since it typically only applies to purchases with five or more installments.

Even though most "pay-in-four" products are exempt from those federal rules, California has classified some pay-later products as loans. The California Department of Financial Protection and Innovation settled with three "buy now, pay later" companies last year over charges they had made illegal loans.

As a measure of Congress' increasing interest, the House Financial Services Committee recently held a hearing entitled "Buy Now, Pay More Later?" Legislators are concerned about consumer protections, disclosure, credit reporting and consumers taking on unsustainable debt.

"The pay-in-4 business model ... has been criticized by some for being specifically designed to evade lending regulation such as the Truth in Lending Act," Democratic Rep. Stephen Lynch said.

But pay-later companies say that delinquency rates are low overall and lower than credit cards. Klarna has said its delinquency rate is less than 1% globally. The companies say they use sophisticated underwriting to select consumers that are able to pay back their debts.

However, many "buy now, pay later" companies only do a soft credit check, if any. If they don't do a hard credit check, they won't know when consumers are using multiple "buy now, pay later" providers — and therefore don't really know whether consumers can pay for their purchases.

"There are troubling indications that BNPL products may lead consumers to incur debt they cannot afford to repay. Disturbingly, part of the business model of some BNPL providers may count on consumers who do not pay on time and who incur late fees," said Lauren Saunders, an associate director at the National Consumer Law Center, at the House hearing. PayPal recently eliminated late fees, matching Affirm's longstanding practice, while Klarna and Afterpay do charge late fees.

It's unclear if or when regulators will force changes in "buy now, pay later." Brue said that the industry "is certainly ripe for regulation … I do think that there's a need for more regulation around it, or there's just a need for the industry to come up with some standards and shared visibility into consumer debt."

The companies have already made some changes ahead of regulation, and could make more. Last month, in response to the U.K.'s upcoming crackdown, Klarna added a "pay now" option for consumers to pay what they owe in full.

"Buy now, pay later" companies grew quickly by filling a need for cheaper, more convenient credit — and exploiting some gaps in regulation. But like other startups in regulated industries, they will have to come to figure out how to fit into the existing rules. Otherwise regulators may well figure it out for them. The question is what those changes will cost them.