Regulatory and Demographic Shifts Have Altered the Path to Credit for Younger American Consumers. Those Shifts Have Opened up Le

PAYMENTSSOURCE ISSUES + ACTIONS Installment Lending: More Profit at the Point of Sale Regulatory and demographic shifts have altered the path to credit for younger American consumers. Those shifts have opened up lending opportunities, particularly at the digital point of sale. Merchants, startups and financial institutions are all vying for a share of this (potentially very) lucrative business.

FOR RELEASE DECEMBER 2018 PAYMENTSSOURCE ISSUES + ACTIONS

Installment Lending: Tapping Opportunity At the Point of Sale

INTRODUCTION The recent transformation of the checkout experience, fueling the rapid growth of the installment lending industry targeting younger consumers, has been at times surprising, and yet still highly predictable. Fintech firms such as Affirm, Bread Finance, Klarna, PayPal Credit and others regularly announce partnerships with retailers to provide short-term financing to customers lacking credit cards or not desiring to use them. A consumer can conceivably shop for items such beds (Saatva Mattresses), eyeglasses (WarbyParker.com), exercise equipment (Peleton) and appliances (Shoppers Choice) without having any payment method available up until they reach the point of sale or checkout page.

In response to the encroachment by these startups on the traditional checkout experience and installment lending industries who have served consumers with poor or limited credit, banks such as Comenity Bank, Wells Fargo and Synchrony have rolled out their own versions of online installment loans to cater to this group of credit hungry consumers - typically in the form of deferred interest loans based on cards. This battle for e-commerce retailer-sourced loans has resulted in increased access to online installment loans for consumers and increased sales of the goods or services that they may purchase. In the past, installment loans in both physical and e-commerce channels had been reserved to finance expensive goods including furniture and jewelry. However today, these loans are now available to make small purchases starting as low as $50 which could be used to purchase t-shirts and dresses.

The growth of the industry can be linked to the advent of the CARD Act of 2009 coupled with the rise of the e-commerce channel. When the CARD Act was passed it outlawed marketing of credit cards to consumers under 21, eliminated marketing of credit cards on college campuses and banned retroactive rate increases on credit cards. These changes altered the credit card business model by cutting off access to younger consumers, eliminating the penalty “stick” of universal default to proactively target those who abused other issuers’ cards and limited their overall ability to hike interest

rates at will. The traditional pathway to gaining access to credit cards in college was now eliminated and the willingness of card issuers to serve young, thin credit file (limited credit history) consumers was severely dampened.

Meanwhile, the growth of e-commerce shopping has boomed in the last 10 to 15 years. The U.S. Department of Commerce announced that in the third quarter 2018 the e-commerce channel comprised 9.8% of all U.S. retail sales, up 14.5% from the third quarter of 2017. In the first quarter of 2009, when the CARD Act was enacted, e-commerce represented roughly 4% of U.S. retail sales.

At the same time, due to rising e-commerce fraud, many retailers are eschewing debit cards and demanding that consumers use credit cards instead as they provide stronger protections for both retailers and consumers. The net result is that consumers without credit cards are being left in a lurch when it comes to shopping online. It has also represented a massive opportunity for creating the online installment lending industry.

A SourceMedia Research survey of e-commerce retailers provides further insight on the market dynamics of the online installment lending industry. In this survey, SourceMedia visited the websites of 146 retailers between November 15th and December 2nd, 2018 to determine their current loan offerings as well as current payment acceptance practices. The list of retailers was compiled using four different lists: The NRF’s Top 100 Retailers, NRF’s Hot 100 retailers, Inc.’s Private Titans list and the Inc. 5000 list (retailers). Only retailers selling to consumers (B2C) were considered and restaurants, gas stations, pharmacies, grocery stores, and B2B merchants were dropped.

ABOUT THIS REPORT

Issues + Actions reports are produced by the editors of American Banker and PaymentsSource. In addition to the retail website research, interviews were also conducted with senior executives at the online lending firms and private label card issuers.

The report examines the current state of the online installment lending industry from the perspective of how consumers are accessing it through the most popular retailers. This is where the battle for consumer wallet is being fought and how it is changing the buying habits of the two youngest generations – Millennials and Gen Z.

Each report provides exclusive and authoritative analysis and insight on a topic of vital interest to the operation of a banking company. The target readership includes senior executives, line-of-business leaders, marketers and technology providers seeking deeper, more actionable industry perspectives, whether as clients or competitors. The reports are available for purchase singly or by subscription.

This report’s primary narrative was written by Michael Moeser. American Banker is the leading resource for commercial banking professionals and PaymentsSource is the leading information resource for payments professionals. American Banker and PaymentsSource are SourceMedia brands and support a full line of professional content as well as research, data and conferences.

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KEY FINDINGS

• Whether a retailer is predominately brick and mortar or digitally focused, the blurring of consumers’ shopping habits has forced many retailers to have some presence in both channels. However, the rapid growth of digital commerce is too hard for retailers born in the physical world to ignore as it leaves them vulnerable to more nimble online competitors. The reality is that most of these retailers will use the internet channel as a low-cost way to serve consumers, shipping items from their warehouses or stores. Just over 90% of the 146 retailers surveyed sell their wares online.

• As more consumers visit retailer websites with the intention of making a purchase, the types of payment forms being accepted at checkout becomes more important. All of the 132 retailers accepted Visa and Mastercard credit cards and only a few declined to allow American Express or Discover. In contrast, only 25 retailers accepted debit cards, or less than one in five.

• A credit card preferring e-commerce channel has an opportunity to offer small-dollar loans in partnership with firms willing to take the risk to underwrite thin credit file consumers. It also creates a chance for private label credit card issuers who have specialized in subprime and thin file consumers to re-invent themselves. Instead of selling credit cards to consumers who may not want them, the issuers can sell installment loans as part of the payment process, tying those loans to an open credit line or card.

• Retailers would rather use a third party to offer installment loans than accept debit cards. There were 50 retailers out of 132 surveyed who offered installment loans or about 38%, a much higher figure than those who accepted debit cards, roughly 19%. Almost all of the retailers used a third party such as a bank or fintech startup to underwrite and collect on the loan. Very few of the loans offered were closed-ended and many offered introductory “teaser rates” such as no interest for a short period of time to attract new borrowers.

• Despite significant attention paid to startups, banks are still very much in the installment lending game. Much attention is given to firms such as Klarna, Bread Finance and Affirm due to their no interest introductory offers and great customer experience. However, the real story is that private label credit card issuers have leaped at the opportunity to capitalize on this chance to re-invent their business model at the point of payment. Over half (57%) of the installment loan offers came with card- based open lines of credit from a private label bank.

• The nature of the installment loan has changed to fit the new type of shopper who tends to be riskier, yet only seeks small amounts to borrow. About half of the installment loans being offered listed minimum purchase amounts with the remaining ones having no minimum. For the loans that listed a minimum purchase amount, only four demanded the consumer spend $399 or higher. On the opposite end of the spectrum, two loans had minimum purchase amounts of $50. The preferred amount for these micro installment loans appears to be in the range of $99 to $299.

• The important features of many of the popular installment loans currently being promoted at checkout are that most are open-ended, with a teaser introductory period and savage subprime “Go To” rates that are retroactive to the loan origination date. All of the open-ended loans surveyed were retroactive (deferred), which means that loans not fully repaid by the end of the introductory period are charged interest applied retroactively to the opening principal amount from the origination date.

• Most installment loans offered at checkout tended to be only six months or one year in duration with many of those being open-ended (deferred interest) loans. The longer-term loans of 24 months or greater tended to focus on two specific industries – furniture and telecom – and included more closed-ended loans. Mobile network operators such as AT&T and Verizon Wireless have shifted from offering large phone upgrade bonuses costing hundreds of dollars to providing consumers with 24- to 30-month interest free loans with each monthly payment added to the phone bill.

• While private label store card programs may have fallen out of favor with all but the largest retailers, when combined with deferred interest loans, they represent an opportunity to attract more customers and increase electronic shopping cart sizes. Only 50% of the 132 retailers surveyed have bank-issued retail card programs and only 22% have both a bank- issued retail card program with deferred interest loans being offered.

MOST RETAILERS ENGAGE IN E-COMMERCE

Whether a retailer is predominately brick and mortar, e.g., Walmart or digitally focused, e.g., Amazon, the blurring of consumers’ shopping habits has forced many retailers to have some presence in both channels. However, the rapid growth of digital commerce is too hard for retailers born in the physical world to ignore as it leaves them vulnerable to more nimble online competitors. The reality is that most of these retailers will use the internet channel as a low-cost way to serve consumers, shipping items from their warehouses or stores. Just over 90% of the 146 retailers surveyed sell their wares online. Only a few holdouts such as Ross Stores and Ollie’s Bargain Outlet use their web presence to act as store locators and places to post the latest sales flyers (see Figure 1).

The ability of online merchants to compete more heavily on price has changed consumer buying habits and blurred the lines between channels. Buy online and pick up in-store has been embraced by physical retailers as they seek to avoid the fate of becoming a showroom for consumers to try on shoes or test out TV sets before making the purchase online. While stories of companies who failed to see the shift in consumer buying habits, there is no need to look into the history books. The recent bankruptcy filing of Toys R Us makes it clear that not having a strong digital presence can be costly.

E-COMMERCE REQUIRES A DIGITAL PAYMENT FORM

The growth of e-commerce is being driven by a combination of factors. Most notably is the widespread consumer adoption of smartphones, tablets, and laptops which translates into an ability to shop virtually anywhere at any time of the day or week. The second most notable factor is that digital shopping allows for greater price comparisons, better product selection and improved services since merchants must now compete for their business in order to survive. Finally, while Millennials may be getting the bulk of the media coverage for their proclivity to make digital purchases, the myth that older consumers prefer to visit physical stores is just that – a myth. A 2017 study of internet shoppers by the package and parcel shipper, UPS, found that 53% of Millennials made an online purchase in the last three months compared to 52 % of non-Millennials. In other words, everyone likes to shop online, not just the younger generation.

As more and more consumers visit retailer websites with the intention of making a purchase, the types of payment forms being accepted at the virtual checkout aisle become more important since they will dictate how easy it is to shop and identify those who needs assistance in completing a purchase. All of the 132 retailers surveyed who sell online accepted Visa and Mastercard credit cards and only a few declined to allow American Express or Discover (see Figure 2). In contrast, only 25 retailers accepted debit cards or less than one in five – not exactly a digital welcome mat for the debit card- wielding shopper.

For younger consumers, those with weaker credit histories and people who want to avoid debt, obtaining a credit card with a sufficient credit line can be a major challenge and even act as a deterrent to shopping online. In Experian’s 2017 State of Credit report it revealed that the average Baby Boomer held 3.53 credit cards compared to 1.44 for Gen Z consumers (born in 1996 or later). PayPal does represent an alternative payment option for consumers wanting to pay with ready funds and not credit, however its coverage was just over two-thirds of the retailers.

So why is there such a disparity between credit and debit acceptance and what opportunities does it create? The simple notion that retailers prefer credit because it allows consumers to spend more money than they have in their bank accounts could be a partial answer, but not the whole answer. Consumer preference to use credit cards for online purchases is also a partial answer since credit and debit cards are treated differently under consumer protection laws in cases of fraud with credit cards having the highest level of safety. However, probably another big driver is what happens in the case of fraud – the time and resources needed to deal with it and reputational risks to the merchant.

Even when merchants follow the anti-fraud rules and chargeback policies set by the card networks and their merchant acquirer, fraud will still occur in e-commerce. In the case of credit, by law the maximum loss allowable is $50 and could fall to zero courtesy of the card networks. For example, Visa states that when its credit cards are processed on its network, the zero liability policy is in force. Since all Visa credit cards are processed on Visa Net all the time (unless the network falters, which is rare) the consumer suffers no loss. When the consumer notifies their bank, the fraud is immediately credited back to their account and the bank is left to determine where the fraud occured. (Should the consumer ever call the merchant, the merchant only needs to remind them to call their issuer.) The net result is that the fraud and potential loss sits with bank.

In the case of debit (and using Visa as an example) the rules are different and fraud not only places a strain on the merchant’s resources, but may also expose the store to reputational risk. The merchant is allowed to choose which network processes its debit transactions and Visa clearly states that if another network processes its debit cards, then the zero liability policy no longer applies. Federal law states that if a consumer reports their debit card has been comprised two business days after the first incidence of fraud, they are liable for $500 of loss. The bank may take one or two weeks to return funds stolen from a consumer, minus the $500, back to their account as they investigate. Since unhappy consumers are more likely to use social media to complain, it creates a reputational risk if the consumer tells the world not use a merchant’s e-commerce website. In this case, the result is that the fraud and potential loss is shared between the bank and the consumer with an unhappy merchant in the middle.

The opportunities a credit card preferring e-commerce channel creates include offering small dollar loans in partnership with firms willing to take the risk to underwrite “thin credit file” consumers. It’s also a chance for private label credit card issuers who have specialized in subprime and thin file consumers to re-invent themselves. Instead of selling credit cards to consumers who may not want them, the issuers can sell installment loans tied to an open credit line or card. In some cases, the issuers don’t actually issue a card, rather keep a line open at the retailer for the consumer’s future use.

PREVALENCE AND NATURE OF ONLINE INSTALLMENT LOANS

Retailers would rather use a third party to offer installment loans than accept debit cards. There were 50 retailers out of 132 surveyed who offered installment loans or about 38%, a much higher figure than those who accepted debit cards, roughly 19%. Almost all of the retailers used a third party such as a bank or fintech startup to underwrite and collect on the the loan. Very few of the loans offered were closed-ended and many offered introductory “teaser rates” such as no interest for a short period of time to attract new borrowers – things retailers love to promote as they don’t carry the risk and it helps drive sales. It was also common for a retailer to promote multiple loans in varying lengths such 6, 12 and 18 months from the card issuer or startup. There were 91 different loan types offered by the 50 retailers

Despite significant attention paid to startups underwriting eyeglasses at WarbyParker.com or training bikes at OnePeleton.com, the banks are still very much in the installment lending game. Much media attention is given to firms such as Klarna, Bread Finance and Affirm, or the PayPal lending division PayPal Credit, which itself was an acquired startup (BillMeLater) due to their no interest introductory offers and great customer experience when signing up for a loan. However, the real story is that private label credit card issuers have leaped at the opportunity to capitalize on this chance to re-invent their business model. Over half (57%) of the installment loan offers came with card-based open lines of credit from a private label bank (see Figure 3). Additionally, one retailer offered both an installment loan from a private label issuer (Comenity Bank) and a loan from a startup company (Affirm) to maximize consumer choice.

The nature of the installment loan has changed to fit the borrower who tends to be riskier, yet only seeks small amounts to borrow. About half of the installment loans being offered during checkout listed a minimum purchase amount with the remaining ones having no minimum. For the loans that listed a minimum purchase amount only four demanded the consumer spend $399 or higher (see Figure 4). On the opposite end of the spectrum, two loans had minimum purchase amounts of $50. The preferred amount for these micro installment loans appears to be in the range of $99 to $299 – almost the exact amount of money before tax for a pair of Felix eyeglasses in tortoise shell from the millennial-loving eyeglass e-commerce retailer, Warby Parker, in single vision ($95) or progressive vision ($295). Finally, it was common for retailers to provide multiple loans with different minimum purchase amounts. For example, a retailer may promote a zero percent loan for six months with a $99 minimum purchase and a zero percent loan for 12 months with a minimum purchase of $299.

The important features of many of the popular installment loans currently being promoted at checkout are that most are open-ended, with a teaser introductory period and a “Go To” rate. This rate is typically higher than standard credit card rates and is applied retroactively to the entire loan from the origination date. So if a consumer pays a six month zero interest loan in seven months and the Go-To rate is 25%, the loan is transformed into a 25% loan for seven months. These are also known as deferred interest rate loans and deferred interest store cards since the interest is being deferred and only applied if the loan is not paid off after the introductory period.

Two-thirds of the open-ended installment loans surveyed have Go-To APRs of 27% or higher, which in the U.S. would be considered deep subprime credit card rates (see Figure 5).

The majority of installment loans offered at checkout tended to be only six months or one year in duration with many of those being deferred interest loans (see Figure 6). The longer-term loans of 24 months or greater tended to focus on two specific industries – furniture and telecom and included more closed-end loans. The telecom installment loan is a new phenomenon in the last 5 to 10 years as mobile network operators such as AT&T and Verizon Wireless have shifted away from offering large phone upgrade bonuses costing hundreds of dollars to providing consumers with 24 to 30 month interest free loans with each monthly payment being added to the regular phone bill.

THE HIDDEN OPPORTUNITY FOR PRIVATE LABEL CARD ISSUERS

While private label store card programs may have fallen out of favor with all but the largest retailers, when combined with deferred interest loans, they represent an opportunity to attract more customers and increase electronic shopping cart sizes. Only 50% of the 132 retailers surveyed have bank-issued retail card programs and only 22% have both a bank-issued retail card program with deferred interest loans being offered (see Figure 7).

The private label card remains to be a vibrant financial product with a significant amount relevance today – despite a slow and gradual decline mirroring that of large shopping malls and department stores. It could be argued that post the 2009 CARD Act, which took away starter credit cards from college students and young adults, it represents an excellent pathway to building credit history. While private label cards can’t compete with the rich rewards of a Chase Sapphire Reserve Visa card, they also don’t come with its hefty annual fee. Also the lower credit lines of private label cards tend to keep consumers who are new to credit from accruing massive amounts of debt.

CONCLUSION – EXPECT INCREASED DEMAND FOR MORE INSTALLMENT LENDING ON E-COMMERCE WEBSITES

The inability for digital shoppers to use debit cards is likely to lead to an increased demand for more installment lending on e-commerce websites and mobile apps. As Gen Z consumers grow into adulthood and begin to digitally shop in earnest over the next 5 to 10 years they will need greater access to flexible lending solutions to help them complete purchases. Beyond Gen Z, as e-commerce continues to crowd out physical retail sales, there will be an enhanced opportunity to sell low dollar, short-term installment loans to a wide array of consumers in order to facilitate digital shopping.

Convincing retailers to add retail store cards where none exists may be an uphill battle in today’s market, however, convincing them to add deferred interest loans tied to existing card programs to move merchandise should not be. Also, the emphasis on these new loans should be to offer smaller credit lines that would appropriately reflect potential customers who enter through the e-commerce website.

Private label issuers and banks have an opportunity to provide short-term loans to retailers that don’t already offer them on their websites or have an existing retail card program. This is particularly true of small retailers that may serve a wide community of shoppers who may only periodically visit them and therefore not wish to obtain a credit card from the merchant. Similarly, the growth of fintech startups serving small dollar, short-term loans to the e-commerce channel should be expected to continue since these firms have developed a solution that has resonated with shoppers who normally avoid credit cards.

Risk scoring models and credit bureaus need to adapt to Millennial and Gen Z consumers’ lack of access to credit and low credit card ownership rates. Gen Z will be the first generation that will have been largely locked out of credit cards until well into their 20’s. Lenders, credit bureaus and risk analytics firms will need to step up to the challenge of providing realistic credit scores so that these consumers can be underwritten with reasonable terms, i.e., prime or near-prime like interest rates. Otherwise, it ay dampen lenders’ ability to make more loans and push these consumers away from traditional borrowing.

The lending industry, both private label card-based firms and the fintech startups, need to work together to self-regulate the growth of deferred interest loans and provide remedies to consumers in trouble or risk future potential regulatory actions. The hidden subprime interest rates and ease with which inexperienced consumers can obtain these loans could appear to a regulator as predatory practices. When industries fail to police themselves, the end result is often regulatory action such as the CARD Act of 2009 and the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act banned many financial service industry practices that were considered as Unfair, Deceptive and Abusive Acts and Practices, or better known as UDAAP. The UDAAP acronym is now used by regulators and consumer watchdog groups to measure the fairness of consumer financial products. It is best to be in front of the situation and part of the solution, rather than to be behind the curve on regulatory actions that could change a lender’s business model.