'Buy now, pay later' has become gateway drug into debt, according to Fed study

The rapidly growing yet largely unregulated market of buy now, pay later (BNPL) loans has become a lifeline and gateway drug into debt-financed spending for lower-income Americans, according to a new Fed study.

The study delved into the psychology of using BNPL among "haves" and "have-nots." One of the major findings was that financially fragile and stable households both used BNPL but for different reasons.

For instance, lower-income households depend on BNPL as a daily financial crutch, typically for small purchases that would otherwise deplete their bank accounts.

"The financially fragile are disproportionately likely to use BNPL at higher frequencies and have embraced it as a regular payment option," the report stated.

Indeed, nearly two-thirds of financially insecure borrowers have used BNPL at least five times in the past year to stay afloat, making them about three times more likely to use these loans compared to well-off households.

Conversely, borrowers from more financially stable households use BNPL less often, mainly to circumvent the high interest rates of credit cards.

Another nuance between the "haves" and "have-nots" involves the BNPL transaction size. While neither group uses BNPL for major big-ticket items, there is a distinction in their buying habits.

Roughly two-thirds of financially fragile borrowers use the loan for purchase amounts below $250, while those in the financially stable camp are likely to use it for purchase amounts up to $2,000.

If the 2023 holiday season is any indication, the BNPL floodgates could be set to open, during which time "many shoppers used BNPL for the first time," according to the New York Fed.

The thinking is that once the hurdle of "first use" is cleared, there’s nothing stopping borrowers from using BNPL again.

BPLN's lifeline could be gone in recession

Citi's chief U.S. economist Andrew Hollenhorst believes there is a perfect storm brewing in which the U.S. economy will not only slow down but fall into a recession by the middle of the year.

He told CNBC, “There's this very powerful and seductive narrative around a soft landing, and we're just not seeing it in the data.”

While at first glance economic indicators paint a rosy picture, including a strong labor market, a resilient consumer, and GDP expansion, there is more to the numbers than meets the eye, Hollenhorst suggests.

“The question is where are these forward-looking indicators showing us that we're going to go,” he said.

The Citi economist is worried about the labor market, which despite a blockbuster 353,000 jobs added to the economy in January, could be misleading.

The fine print presents a one-two punch in which both the number of hours worked and the full-time workforce are falling. As Creditnews recently reported, layoffs are mounting in the tech sector, among others.

If the U.S. economy were to follow in the footsteps of the U.K. and fall into recession, lending standards are likely to tighten, leaving consumers with fewer flexible payment options at checkout.

That could derail the financial lifeline that BNPL provides to households, particularly those that are deemed financially fragile.

Consumer spending off to a weaker start

While the U.S. economy has been able to stave off a recession so far, chinks in the armor are beginning to show, particularly with consumers.

Retail sales—a key barometer of consumer spending—tumbled 0.8% in January, marking the biggest slide in almost a year.

The drop was bigger than expected, even as some economists cautioned against reading too much into it due to extreme weather events that swept the country.

Major retailers are also warning about weaker consumer spending, with Walgreens’ CEO Tim Wentworth recently telling investors: “I think the state of our consumer is probably not as buoyant as perhaps some of what you read about consumers more generally.”

Coca-Cola’s chief executive, James Quincey, said consumers are still being squeezed by inflation.

“What has been important to understand is there’s a section of the population that has come under pressure from disposable income,” he said, adding that Coca-Cola has been focusing on improving affordability for cash-strapped consumers.

Kathy Bostjancic, chief economist at Nationwide, says consumers are looking to “rein in their spending this year after drawing down the pandemic-related savings,” leading them to lower-cost retailers like Walmart.