Reinventing credit cards: Responses to new lending models in the US

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Credit cards have long been one of the most popular methods of making payments and accessing unsecured borrowing in the United States, accounting for 37 percent of consumer purchases by dollar value in 2021.1 But their market position is gradually being undermined by the growth of point-of-sale (POS) financing offerings that combine installment lending with the convenience of card payments. US issuers could by 2025 lose up to 15 percent of incremental profits to newer forms of borrowing, based on our simulation of the potential impact of buy now, pay later (BNPL).

Alarming as that may sound to credit-card issuers, it is far from the whole story. Issuers have decades of experience and well-established relationships with consumers and merchants to help them compete. What’s more, credit cards have several deep-rooted advantages over other credit products. Many consumers engage with credit cards daily when purchasing goods and services. The spending data generated in this way gives issuers valuable insights into consumers’ preferences and needs. And credit cards are often part of a complementary suite of offerings alongside deposits, consumer loans, and other products, helping to reinforce customer loyalty.

Issuers can tackle the challenges they face by building on these strengths. They can reimagine their products to meet consumer needs, introduce tailored solutions to reach younger consumers, drive engagement, and rethink card economics.

A strong track record—but can it be sustained?

In the United States, credit cards are one of the best-performing businesses in financial services, with a return on assets of 3.6 percent in 2020. Credit cards are also a primary method of unsecured borrowing for US consumers, accounting for 78 percent of balances.2 Over the past few years, transaction volumes have grown by 10 percent per year, reaching $49 trillion in 2021.

However, today’s issuers face circumstances that make profitable growth harder to sustain. Their profits rely mainly on revolvers, or customers who carry a balance on their credit-card account from month to month (see sidebar “Modeling revolver and transactor economics”). Revolvers make up around 60 percent of credit-card accounts, but they generate 85 to 90 percent of issuers’ revenues, net of rewards. Profit per account stands at around $240 for revolvers but at just $25 for transactors, or customers who pay off their balance every month (Exhibit 1). The difficulty for issuers is that the share of revolvers has started to decline over the past few years.3 At the same time, reward spend is growing, low loss rates are heading back toward normal levels, and funding costs are rising. The net effect of these trends is a squeeze on issuers’ margins.

Average revenue and profit per account are significantly higher for revolvers than for transactors.

Enter the BNPL players

Traditional sales finance, commonly called layaway, has been available in the US for decades, but for credit-card issuers, the risk to profitable growth comes from the rapid growth of a relative newcomer to the payments arena: technology-enabled BNPL. Consumers are choosing BNPL for a variety of reasons, including lower APR (starting at 0 percent for some purchases), predictable repayments, and the convenience of using a payment method that is integrated into online customer journeys and shopping apps. The sustainability of POS financing is subject to debate: pay-in-4 providers have historically made a loss despite positive unit economics, BNPL players now face a more challenging macroeconomic environment with rising interest rates and defaults, and questions have been raised about the risk associated with BNPL (see sidebar “Risks associated with POS financing”). Nevertheless, it seems clear that BNPL has changed consumers’ expectations of the borrowing experience and expanded the role lenders can play in shopping journeys.

Providers such as Affirm and Afterpay offer consumers seamless borrowing at the point of sale for small- and mid-ticket purchases. In doing so, they could erode a fraction of issuers’ volumes.4 The exact size of that fraction is hard to establish. McKinsey’s US Digital Payments Survey indicates that 39 percent of BNPL users making a purchase would otherwise have paid with a credit card. In another survey, 62 percent of users expressed the belief that BNPL could replace their credit card—although only about a quarter said they would want it to do so.5

What is certain is that credit-card holders are adopting BNPL. Among the users of mid-ticket POS financing—typically consumers with loans of $300 to $3,000 on purchases of furniture, appliances, electronics, and other durable goods—almost 95 percent have credit cards (Exhibit 2). So do 85 to 90 percent of pay-in-4 users, who typically have six-week merchant-funded loans of less than $300 on purchases of apparel, beauty products, and accessories.

Most point-of-sale financing users say they have credit cards.

As well as capturing transaction volumes, BNPL providers are doing something else that could undermine issuers’ business: acting as an entry product for younger consumers who are new to credit. Although use among older customers is growing, BNPL attracts a predominantly young audience: 37 percent of Gen Z and 30 percent of millennials are reportedly users, compared with 17 percent of Gen X and 6 percent of baby boomers.6 Issuers have traditionally relied on younger consumers as a source of growth. Since 2017, credit-card spending has increased by 11 percent a year among those under 40 while remaining flat among those over 40, who account for 62 percent of this spending. If BNPL providers continue to attract large numbers of young consumers and are able to retain them as they grow older, credit-card volume growth is likely to suffer.

BNPL providers such as Affirm, Afterpay, Klarna, and Sezzle are also starting to shape the wider retail ecosystem by developing shopping apps that drive consumer traffic and stickiness. Users of Afterpay and Klarna are engaged and loyal, making transactions via these apps almost every month. Klarna reports that customers who use its shopping app make purchases via Klarna three times more often than nonusers.

In parallel, established payments providers are expanding into BNPL and developing comprehensive financing and payments offerings for merchants and consumers. Examples include Block’s acquisition of Afterpay7 and PayPal’s introduction of credit and pay-in-4 options.8

How BNPL could change the payments landscape

We see four trends in BNPL that are likely to affect—or are already affecting—the strategies of issuers, as well as banks, fintechs, and other payments providers. BNPL apps are playing a greater role early in shopping journeys and offering a broader range of services. At the same time, payment networks are making POS financing widely available, and financial institutions are getting into the game.

Trend 1: BNPL apps are becoming a starting point for consumers’ shopping journeys

BNPL providers are starting to position themselves primarily as integrated apps that combine shopping with consumer financing. This strategy enables them to build customer loyalty and generate affiliate fees from nonintegrated merchants. This trend is likely to intensify as rising interest rates push up the cost of funds and merchant discount rates continue to decline, squeezing BNPL providers’ margins and prompting them to turn to affiliate fees as an additional source of revenue.9

Trend 2: BNPL providers are venturing beyond installment lending

As BNPL players continue to expand their customer base, they are introducing new financial and loyalty products to meet their young customers’ evolving needs and to maximize customers’ lifetime value. Early examples include Klarna’s credit card and Affirm’s Debit+ card, which allow consumers to make staged payments in offline channels and at nonintegrated merchants. Other examples include Klarna’s checking accounts in Germany and Afterpay’s Money app in Australia, which offers savings accounts and a debit card. Over time, moves like these could extend to other products: high-yield savings accounts, loyalty programs, and other financial or shopping-related services.

Trend 3: Payment networks are providing access to consumer POS financing at scale

Capitalizing on their access to merchants and ownership of credit-card transaction processing, payment networks are rolling out solutions that enable greater use of BNPL. For example, Mastercard Installments allows customers to access a BNPL product via a virtual card issued by a bank or fintech,10 and with Visa Installments, customers can split purchases on eligible Visa cards into equal installments at the point of purchase.11 Mastercard Installments technology will be used by Apple Pay for their recently announced BNPL product, Apple Pay Later.12 Network BNPL solutions could make BNPL more accessible for consumers, small merchants, and merchants from categories with lower BNPL penetration. Payment networks wanting to raise the standard for customer experience could also allow customers to choose the best payment method—say, credit card, on-card BNPL, or virtual-card-enabled BNPL—for any transaction, depending on ticket size, credit-card limit, pricing, and other factors.

Trend 4: Financial institutions are expanding their reach by entering POS lending

Credit-card issuers and other financial institutions are exploring participation in POS lending. Some lenders are setting up their own offerings, such as Citizens Pay; others are entering the market via acquisitions, such as Goldman with GreenSky, Regions Bank with EnerBank, and Truist with Service Finance. Lenders’ robust balance sheets, strong brands, ability to underwrite big-ticket installment loans, and a large and loyal consumer base give them a competitive advantage in this new arena. In time, POS financing could become a customer-acquisition channel for lenders, as well as a means to increase their share of wallet by cross-selling traditional banking products to POS financing users.

The extent to which these trends will reshape POS financing, and consumer lending more broadly, will depend on multiple factors, including consumers’ willingness to start their shopping journey on BNPL shopping apps, the ability of networks and issuers to provide a compelling user experience and drive adoption, and lenders’ ability to integrate and grow the POS financing businesses they acquire.

How BNPL could affect issuers’ volumes and profits

Three key risks associated with BNPL could significantly affect issuers’ volumes and profits. First, issuers could lose younger consumers who prefer financing to be embedded in the shopping experience. Second, BNPL providers could take away some of the revolvers, who are issuers’ most profitable consumer segment. Third, as BNPL providers start to own customer relationships, issuers may find they must spend more on customer acquisition to compete.

To understand the potential impact of BNPL on US issuer volumes and profits, we ran a simulation based on three different scenarios for credit-card spending over the next few years. The simulation revealed that US issuers could lose between 2 and 15 percent of incremental profits to newer forms of borrowing by 2025 (see sidebar “Simulating BNPL’s potential impact on credit-card volumes and profits”).

In markets with more mature POS financing offerings, significant volumes have already shifted from credit cards to BNPL. In Australia, for instance, credit-card accounts have declined by about 6 percent a year, and BNPL accounts have grown by more than 40 percent a year since 2017 (Exhibit 3). Because of its higher interchange fees and different market fundamentals, the US may see a more muted shift than in Australia, but it is evident that replacement is under way.

In Australia, the growth in buy now, pay later accounts has been accompanied by a decline in credit-card accounts.

Findings from the 2021 McKinsey Digital Payments Survey suggest that the credit-card business is more likely to be cannibalized by mid-ticket POS financing than by pay-in-4 providers. That’s because users of mid-ticket POS financing are more likely to have a credit card and to use it if BNPL is not available, as shown in Exhibit 2.

Private-label credit cards are popular among merchants because of their favorable economics, but they are likely to see more impact on their volumes than general-purpose cards. For one-off purchases at a particular merchant, BNPL tends to offer consumers experiences that are more seamless, more transparent, and in some cases more affordable than using a private-label credit card.

Finally, BNPL’s impact on credit cards is likely to vary by industry and product category. In travel, where cobranded cards offer generous rewards for customer loyalty, BNPL represents only about 2 percent of consumer transactions. In contrast, furniture, mattresses, electronics, and appliances could see considerable inroads from BNPL providers as purchases continue to shift to online channels and private-label card penetration stagnates.

How issuers could respond

As issuers face a changing consumer-lending landscape and the possibility of losing credit-card business to BNPL providers, they should prepare a thoughtful response. Options they might consider to sustain and grow their unsecured consumer lending could include reimagining their products to meet customer needs, reaching younger consumers with tailored solutions, driving consumer engagement, and rethinking the economics of their card product.

Reimagining products

Issuers could consider rolling out POS financing products and on-card installment solutions that meet consumers’ need for predictability and demand for financing offered as part of the shopping journey. Fintechs have entered this arena with products such as the Upgrade Card, a hybrid between installment lending and a traditional revolving credit card. When designing their own offerings, issuers will need to carefully consider how a product can deliver sustainable profits while remaining competitive with fintech solutions. That will involve assessing the lifetime value of potential customers, which depends on the issuer’s ability to move customers to offerings with a higher return on assets (ROA) and/or to develop multiproduct relationships with customers.

Reaching younger consumers

Issuers could offer innovative types of credit cards geared to consumers who are new to credit. In Australia, for instance, CommBank and NAB have launched cards that allow consumers to subscribe to a line of credit without being charged interest, although they may in some cases end up paying more in monthly card fees. The appeal of products like these lies in their transparency and simplicity.

Driving consumer engagement

Some issuers and payment providers have acquired e-commerce players that allow them to reduce their customer-acquisition costs or offer new forms of value to boost consumer engagement. Examples include Capital One’s acquisition of Wikibuy, a price-comparison solution, and PayPal’s acquisition of Honey, a coupon-finder service. By becoming a starting point in a shopping journey and offering consumers distinctive value, issuers can increase their chances of staying top of wallet while creating a new revenue stream from affiliate marketing.

Rethinking card economics

Issuers could consider moving toward partly or fully merchant-funded on-card financing offers, rewards, or both to help them sustain their profitability in the face of mounting margin pressures. The key will be to deliver value not only to transactors but also to revolvers, who benefit from BNPL products that are partly or fully funded by merchants.

For US credit-card issuers, the prospect of losing a substantial share of volume and profits to BNPL over the next few years should act as a spur to action. With the right strategic moves, planned and implemented without delay, issuers can give themselves the best chance of stemming likely losses and positioning their business for success in an increasingly competitive arena.

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