Why buy now, pay later never makes money

BNPL is an old product with a new interface. It is a short-term unsecured personal loan, the kind Americans have used since the 1800s for furniture and sewing machines. What changed is scope and friction: it now covers impulse and splurge purchases, and the historically opaque process of application and manual underwriting has become a few taps at checkout.

Adoption was extraordinarily fast. BNPL was $97 billion, or 2%, of the $4.6 trillion spent on global e-commerce in 2020. By 2021 Affirm, Klarna and Afterpay together claimed over 173 million active users, and four in five Americans have used BNPL — on clothing, groceries, gifts and cleaning supplies.

Three trends made it inevitable. E-commerce still has room, since only 14% of global retail is online. Millennials have passed boomers as the largest adult generation and over 70% of them and zoomers prefer to shop online. And customer acquisition keeps getting more expensive, pushing retailers toward discounts that damage the brand.

The credit system it displaced really is hostile. Card interest at around 19% compounds daily, a missed payment costs $40, and a request to raise your limit triggers a hard inquiry that lowers your score. Length of credit history is a function of time, so a young borrower can do nothing but wait. Globally, consumers paid $121 billion in credit card interest in 2019, and Americans owed close to $1 trillion in card debt by August 2022.

Retailers love it because they carry none of the risk. The retailer is paid in full, immediately, at the moment of checkout. Whether the loan is interest-free or twelve months, and whether the customer repays or vanishes, is entirely the BNPL company's problem.

Which turned retailer exclusivity into an arms race. Retailers partner with one provider at a time: Affirm has Amazon, Peloton and Walmart; Klarna has Lululemon, H&M, Nike, Wayfair, Saks and Sephora; Afterpay has Nordstrom, Adidas, Gap, Tory Burch and Bed Bath & Beyond. Klarna leads with over 400,000 merchants, Affirm has 235,000, Afterpay 98,000.

The three are the same company in different jurisdictions. Identical messaging, identical products, identical claims about proprietary underwriting and low default rates. All funnel users into an app for push-notification retention, all tie identity to a phone number rather than an email, and all offer savings accounts.

Scale differs enormously, though. In 2021 Klarna's users bought over $80B of merchandise against Afterpay's $22B and Affirm's $8B. Klarna operates in 45 countries with 145 million customers; Afterpay in 9 with 16 million; Affirm only in the US and Canada with 7 million. Everyone chases America anyway — it is 25% of global retail.

The market has already repriced them. Afterpay was bought by Square for $29B at the peak in late 2021. Klarna scrapped a $50B IPO and raised instead at $7B — an 80% drop from $45B a year earlier. Affirm is the last standalone public one, which is why its filings are the clearest window into the model.

Two streams carry the business. Merchant fees, a commission of 2 to 5% per sale negotiated per retailer, and interest income. Together they are about 85% of Affirm's revenue. Interest grew from $120M to $530M and merchant fees from $132M to over $450M across four years, while users and volume both rose sevenfold.

The commission is higher when the loan is interest-free — Affirm takes a bigger cut precisely where it earns no interest. Against the 1-3% retailers already pay a card processor, a few more points feels fair for a sale that would not otherwise have closed.

Afterpay proves the model's shape by refusing half of it. It offers only interest-free loans, so it charges higher merchant commission at 4-6% and leans on penalties. Merchant fees are 82% of revenue, near 90% in 2021, quadrupling from $200M to $800M. Late fees are 13% of revenue, doubling from $46M to $90M.

And every one of them loses money. Affirm has lost over a billion dollars in four years, from $127M in 2019 to $866M in 2022. Klarna lost $620M and Afterpay $194M in 2021.

The reason is who actually funds the loan. When you click checkout you are submitting a loan application; the BNPL algorithm underwrites it, but a partner bank issues and funds it. Roughly 80% of Affirm's 2022 loans came from Cross River Bank, a New Jersey community bank. Klarna's US loans come from WebBank in Utah; Afterpay's from National Australia Bank and others.

Then the BNPL company must buy that loan back — above what it is worth. The bank does no underwriting and wants no exposure, so within days the loan is repurchased at face value plus an origination fee. On interest-free loans that price exceeds fair market value, which is a guaranteed loss on the most popular product. Affirm names it loss on loan purchase commitment: $73M in 2019 rising to $246M in 2021, and in 2020 it was 27% of operating expenses on its own.

They keep selling the loss-making loan to buy respectable borrowers. A portfolio of only high-interest loans is a portfolio of subprime borrowers, and prime borrowers — who have credit already — will not take one. Interest-free loans are the bait that balances the book. Two fixes are underway: savings accounts, so deposits fund loans directly (Affirm self-funded 20% of loans in 2022 and cut the loss by $40M), and packaging loans into securities while keeping the servicing fee, now 15% of Affirm's revenue at over $250M. That last one is the 2008 structure at a smaller denomination.