What do higher interest rates mean for buy now, pay later?

IIt has been a volatile year for nearly all asset classes as investors focus on persistent inflation and the Federal Reserve’s actions to combat it.

In times of inflation, the Fed tries to raise interest rates to curb demand and dampen rising prices. These changes in interest rates are affecting all markets including the Buy Now Pay Later (BNPL) industry. Companies in the industry are facing headwinds from rising borrowing costs – here are some things to consider before investing in the industry.

Once thriving BNPL firms have come back to earth

“Buy now, pay later” options have grown rapidly in recent years due to low borrowing costs and strong consumer demand for goods. The industry grew at a compound annual growth rate of 85% from 2019 to 2021 as millennials and Gen Z customers turned to low-interest installment plans.

Initially, a few big players dominated the industry, including Confirm (NASDAQ:AFRM), Afterpay and Klarna. Affirm went public in early 2021 and achieved a market cap of nearly $48 billion during the year. The stock has fallen back into orbit, trading at a valuation of just over $5 billion, down nearly 90% from its peak. Klarna, the Swedish bank BNPL, lowered its private valuation to $30 billion during its latest funding round from $46 billion last year.

AFRM Market Cap data through YCharts

What higher interest rates mean for BNPL companies

The industry faces headwinds inflation and rising interest rates. In May the consumer price index up 8.6% year-on-year, higher than economists expected.

BNPL lenders face two problems. First, consumers may find inflation too high to deal with, and could reduce spending on goods and services – meaning fewer lending opportunities for BNPL firms. Second, rising interest rates could make financing these loans more difficult.

To fight inflation, the Federal Reserve commits to raising interest rates. This year, the Fed raised the federal funds rate from near zero to 0.75%. Analysts expect the policy rate reach 3% to 3.25% by mid-2023.

BNPL companies thrived as low interest rates ensured cheaper financing costs and plenty of cash to lend to consumers. However, BNPL companies rely heavily on credit to continue funding their business and the cost of borrowing for these companies has risen significantly over the last year. For example, Klarna’s borrowing costs rose to their highest level ever. As borrowing costs rise, BNPL lenders are finding it harder to grow as fast as they used to.

What I’m looking for before I jump into these stocks

BNPL firms are breaking new ground and will be tested by rising interest rates and a potential slowdown in consumer spending. Companies with banking licenses, such as block inc, which owns Afterpay and privately traded Klarna, could do better because they have deposits that could fund their loans. Interest rates on customer deposits are rising at a slower rate than borrowing costs, which could bring stability to lenders. Earlier this year, Klarna told Bloomberg that 80% to 85% of its loans are funded by customer deposits.

Companies without a banking license, like Affirm, could struggle with rising funding costs, eating into the company’s margins.

The industry is also facing other headwinds, including Apple‘s entry into the room and increasing official examination. For this reason, I will avoid investments here in the near future. Still, I’ll be keeping an eye on and reevaluating interest rates and consumer defaults for companies like Affirm and Block, Inc. over the next few quarters.

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Courtney Carlsen has positions at Apple. The Motley Fool has positions in and recommends Affirm Holdings, Inc., Apple, and Block, Inc. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has one confidentiality policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Virginia C. Taylor