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‘Buy now, pay later’ is coming to credit scores—but key questions still must be answered

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Which came first, the chicken or the egg? How about the credit score or the buy now, pay later plan? It’s a similar conundrum for many people, especially young adults, immigrants and others who are less likely to be rated by traditional credit scoring methods—and therefore may be drawn to alternative funding sources such as buy now, pay later.

There will soon be a much tighter link between credit reporting and buy now, pay later (BNPL), as Equifax recently announced the industry’s first policy for accepting BNPL tradelines into consumer credit files, and Experian is set to debut what they’re calling the industry’s first “Buy Now Pay Later Bureau.” Soon after that, TransUnion—the other major credit bureau—made a similar announcement. However, it’s not entirely clear how any of these will be implemented, and there are some potential unintended consequences for consumers.

The basics of BNPL

Providers such as Affirm, Afterpay and Klarna enable customers to pay for purchases in preset installments. The most common version is four interest-free payments spread over six weeks. Sometimes the plans last much longer, with or without interest.

For example, some people could avoid paying interest on a $2,495 Peloton Bike+ for nearly four years via the fitness company’s partnership with Affirm. Qualified applicants would pay about $58 per month over 43 months with no money down and no interest.

On the other hand, some of Affirm’s plans do assess interest, reaching up to a whopping 30 percent based upon the applicant’s creditworthiness. Klarna, too, has a huge spread between its interest-free plans and others that charge an annual percentage rate as high as 24.99 percent.

For both Affirm and Klarna, the midpoint is similar to the average credit card APR of 16.28 percent. Before committing to a buy now, pay later plan, it’s important to investigate your specific terms. Returning to the Peloton example: $58 per month sounds affordable, but there’s still a danger of overspending. Do you really want to be in debt for the next 43 months to pay off an expensive, non-essential item? Plus, many consumers have several BNPL plans running simultaneously, which further obscures the total cost of ownership.

Who uses BNPL?

Many BNPL users are drawn to the easy access to credit and the instant gratification of obtaining an item now and paying for it over time (hence the “reverse layaway” moniker that some have bestowed upon BNPL). This has become a $100 billion industry, aided by specific retail partnerships and pandemic-related tailwinds such as a surge in e-commerce and greater consciousness surrounding debt and other personal financial matters.

Because they know exactly how much they owe for exactly how many weeks or months, some people prefer BNPL. A credit card’s open-ended structure could keep them in debt for a very long time, especially if they only make minimum payments. Also, BNPL plans are often easier to qualify for than credit cards. Most BNPL providers only conduct a soft credit check. Plus, they aren’t yet governed by federal regulations concerning a borrower’s ability to repay the loan, although the Consumer Financial Protection Bureau recently announced it’s taking a closer look at the industry’s practices.

Clearer credit reporting standards would be nice. BNPL plans are especially popular among young adults, which gets us back to that chicken-or-the-egg dilemma. A January 2022 Bankrate survey found that only 55 percent of Gen Zers (18-25 year-olds) have a credit card. The figure rises to 66 percent of millennials (26-41 year-olds), 77 percent of Gen Xers (42-57 year-olds) and 85 percent of baby boomers (58-76 year-olds).

This is partially because the CARD Act, which took effect in 2010, made it much harder for young adults to obtain credit cards (particularly before their 21st birthday). It also may be self-selecting since many 20-somethings are saddled with student debt and are wary of taking on additional consumer debt. BNPL plans are a form of debt, although many view them differently, perhaps because they’re often short-term commitments with built-in light at the end of the tunnel.

It can be hard to establish a credit history. Experian says at least 49 million Americans cannot be rated by traditional credit scoring systems because there isn’t enough information available about their credit habits. Access to credit has become a big theme in recent years, inspiring alternative credit scoring models such as Experian Boost. And startups such as Petal and TomoCredit are leveraging novel approaches intended to provide credit cards to young adults, immigrants and other historically underserved groups.

BNPL and credit scoring have been mostly separate

To date, the vast majority of BNPL plans have not been reported to the credit bureaus. Affirm reports some of its longer-term plans to Experian, but that’s the exception, not the rule.

Equifax says most consumers in its BNPL pilot program experienced improvements to their credit scores, thanks to their on-time payments, with an average FICO score increase of 13 points. The improvement was even greater (21 points) for individuals with either a “thin” credit file (two or fewer tradelines) or a “young” file (a credit history shorter than 24 months).

I’m all for including “alternative” credit metrics in consumers’ credit reports. In fact, I’m putting “alternative” in quotation marks for a reason. The credit reporting industry tends to view things like streaming services, cellphone plans, rent payments and utilities as “alternative” because they haven’t traditionally counted in credit scoring. But I’d argue that the fundamentals are very similar. These are monthly financial obligations, like credit card bills, car loans and mortgages. It only seems fair to count them toward a consumer’s credit score.

I believe BNPL plans should count toward credit scores, but this needs to be done the right way. There are a few key nuances that still need to be sorted out.

The challenges of adding BNPL to credit scoring

One potential concern is that frequently opening credit accounts typically counts as risky behavior. Too many hard inquiries is a definite no-no because opening many credit accounts at once could suggest a desperate situation. It’s usually advisable to accumulate no more than five or six hard inquiries over a two-year span. This may not apply as much to BNPL users because those tend to be soft inquiries. However, credit scoring algorithms also assess the age of consumers’ accounts (in terms of the average age of those accounts as well as how recently the newest was opened). If every BNPL plan shortens the average age of one’s credit history, they could have an unintended negative effect on credit scores.

Another potential consequence is whether BNPL represents an installment loan or a line of credit. If it’s a line of credit, how will credit utilization be assessed? On credit cards, how much credit you’re using divided by your credit limit is a key component of your credit score. In other words, if you’re using $4,500 out of a $5,000 credit limit, that looks risky to lenders because you’re dangerously close to maxing out that card.

But BNPL plans tend to be underwritten on a transaction-by-transaction basis, rather than a larger, open-ended line of credit. If you’re financing that $2,495 bike with 43 payments of $58 and your “credit limit” is considered to be $2,495, your credit utilization ratio (at least for that transaction) would be elevated for quite some time. This could inadvertently hurt consumers’ credit scores even if they keep up with their monthly financial responsibilities.

Finally, will negative information (such as late payments) be reported? Traditionally, both positive and negative information has been reported to the credit bureaus, although some of the newer credit scoring techniques—such as Experian Boost—only incorporate positive data.

The bottom line

It’s still not fully clear how the credit bureaus will incorporate BNPL into consumers’ credit files. Experian and TransUnion, in particular, seem to be focused on creating BNPL-specific rating systems that lenders can opt into if they choose.

These new systems could avoid the aforementioned unintended consequences of meshing BNPL with traditional loans and lines of credit. They could help lenders isolate how many outstanding BNPL loans a prospective customer has, along with total BNPL loan amounts and BNPL payment histories. But like other new credit reporting methodologies, it will take time for them to become widely used.

Equifax, on the other hand, is committed to integrating BNPL with existing credit reports. The company’s chief product officer, Mark Luber, stresses that this is a consumer-friendly development (assuming the consumer’s BNPL usage is favorable) because these are more widely used than niche metrics.

Luber indicated that BNPL plans are most likely to be viewed as revolving credit, thereby avoiding the concern of frequent account openings and closures. This means that credit utilization is a key factor, too. And he confirmed that both positive and negative information is reported.

Ultimately, it seems like progress that the credit monitoring industry is working to incorporate BNPL plans into its calculations, but these changes won’t happen overnight. Equifax is probably the furthest down the path, but it’s still in the early stages of obtaining data from BNPL providers.

Have a question about credit cards? E-mail me at ted.rossman@bankrate.com and I’d be happy to help.