Buy-now-pay-later plans: Smart spending or financial trap?

Want to purchase something but can’t afford it right now?

Payment plans make it easier for customers to afford high-ticket items that they would otherwise second-guess. However, these apps also make it all too easy for consumers to overspend outside their budgets.

Below, I’ll explain how buy-now-pay-later programs work, outline the pros and cons, and explain when it’s a good idea to use them.

How do buy-now-pay-later (BNPL) programs work?

Buy-now-pay-later (BNPL) programs have become increasingly popular in Canada and are often incorporated into online and retail stores to help customers get approved for short-term financing.

PayBright was launched in 2017 and became the first BNPL service in Canada. Affirm, a US-based BNPL, recently acquired the company for $340 million in 2021.

Unlike traditional financing and credit cards, which require customers to undergo lengthy approval processes, BNPLs make it easy, and customers can usually get approved in less than five minutes.

Pay-in-four vs. extended payment plans

BNPLs typically offer two different programs:

• Pay-in-four: The total payment is broken into four even payments, which are paid bi-weekly.
• Pay monthly: The payment is broken into six or more single monthly payments.

Pay-in-four purchases are typically interest-free. The first payment is made upon purchase, and the three remaining payments are automatically drafted from the user’s bank every two weeks.

Monthly payment plans often incur interest but give the customer more time to complete their payments.

Drawbacks of BNPL payment plans

Buy-now-pay-later plans have caught a lot of flack in recent years and have been accused of targeting younger consumers who may not be as financially literate (or responsible) as their older counterparts who have access to rewards credit cards.

Although companies have made changes to their policies to encourage more responsible usage, there are still some inherent risks to using a BNPL:

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It’s easy to overspend

The main risk of using payment plans like PayBright or Afterpay is that it’s very easy to overspend. A $1,000 purchase seems a lot more affordable when you only have to pay $250 every two weeks.

Prior to these easily accessible payment plans, consumers would have to save up the money, use a layaway plan, or go through a lengthy credit approval process.

BNPLs remove many of these spending barriers, reducing consumers’ time to reconsider costly purchases.

In short — BNPLs can be very bad for impulse buyers.

To limit this, most BNPL companies incorporated spending limits for customers, preventing them from financing new purchases until their balance is paid down.

However, if you’re enrolled with multiple BNPL companies, you could end up in a financial trap where you’re spending far more than you can afford to pay back.

High interest and late fees on missed payments

The great thing about pay-in-four programs is that they’re interest-free. Even monthly payment plans typically offer lower interest rates than credit cards or traditional short-term loans.

However, the flip side is that missed payments are expensive and often come with late fees and exorbitantly high interest rates.

Missed payments can hurt your credit

If you miss multiple payments back to back, your payment plan may default and can be referred to a collection agency. The collection account will then be reported on your credit, which can negatively impact your credit score.

Benefits of BNPL payment plans

While BNPL programs can be risky, they offer many benefits to responsible consumers and can make financing costly items much easier.

No interest on pay-in-four plans

If you’re approved for a pay-in-four plan, the purchase is interest-free. Assuming that you’re enrolled in bi-weekly payments, your plan should be paid off in one or two months.

In the past, you would have had to use a credit card or apply for a loan, both of which can incur costly interest charges.

No hard credit checks

When you apply for a payment plan (monthly payments or pay-in-four), BNPLs will perform a soft credit check to determine your overall creditworthiness.

Unlike the hard credit pulls initiated by traditional lenders and credit card companies, these soft credit checks are not marked on your credit report and won’t affect your credit score.

Buying power increases over time

When you show that you can use BNPL programs responsibly and complete your payment plans on time, the amount you can finance will slowly increase.

When should you consider using BNPL?

Overall, BNPL payment plans have a lot of benefits. As long as they’re used responsibly, they’re often a better alternative to credit cards and short-term loans, which can incur costly interest charges.

What is responsible usage, though?

I think we can all agree that using BNPL for frivolous purchases like designer clothes, overpriced tech, or collector’s items probably isn’t the most responsible choice. This is especially true if the cost of these items is outside of your regular spending budget.

Instead, I recommend using BNPL to finance necessary purchases, such as:

• Car parts necessary for a repair
• Tools for your business
• A computer that you need for work

Not having a reliable computer for work or having to go weeks without repairing your car can result in you losing money and job opportunities. BNPL allows you to finance these costly items upfront, breaking them into more affordable payments you can budget for over the ensuing weeks and months.

In the same vein, purchasing essential tools for your small business is also responsible, as you’ll be able to put the tools to use to help you earn more money, helping you cover their cost.

Are BNPL payment plans a financial trap?

If used irresponsibly for impulse purchases, BNPL payment plans can become a financial trap leading to overspending, late payment fees, and high interest rates.

However, if you use BNPL wisely to cover planned purchases, they can be very helpful and are often less expensive than the interest and fees imposed by credit cards and traditional lenders.

Written for Daily Hive by Christopher Liew, a CFA Charterholder, former financial advisor, and the creator of Wealth Awesome.