How does ‘buy now, pay later’ schemes affect your credit score?

Buy now, pay later, or BNPL, is a payment plan that lets you as a shopper break up your total purchase at checkout into a series of smaller instalments.

Though these plans aren't new, they've recently catapulted into the mainstream, with major retailers like Amazon now offering them. But with promises of convenience, zero interest and minimal fees, many shoppers are wondering, "what’s the catch?"

It could be your credit.

BNPL providers don't typically report on-time payments to the major credit bureaus, so unlike with credit cards or loans, you can't build credit with this type of financing. Some providers will report missed payments, though, which could end up hurting your score.

BNPL and the credit bureaus

Afterpay, an Australian company that provides BNPL payment plans to millions of shoppers, doesn't interact with the credit bureaus at all, including when shoppers first apply for approval.

According to Nick Molnar, co-founder and co-CEO of Afterpay, checking a shopper's credit file has “no positive correlation” to the company's ability to reduce losses. Instead of conducting a soft or hard credit pull, the company applies safeguards like pausing a shopper's account after one missed payment, which Molnar says customers appreciate.

“I think this next generation is looking for these products that have their best interest at heart,” he says. "At its core, that's why we've been able to grow as fast as we have.''

Though this approach means easier approval for those with no credit or bad credit, shoppers can't use Afterpay payments to demonstrate responsible use of credit to the bureaus. On-time payments are the largest contributor in determining credit scores.

Afterpay isn't alone. Other BNPL companies worldwide like Klarna and Affirm also don't typically report payments for their no-interest plans.

This practice is especially harmful for young people who may need to access credit to lease or buy a car, rent an apartment or buy a house, says Bruce McClary, senior vice president of communications for the National Foundation for Credit Counselling, the largest and longest-serving non-profit financial counselling organisation in the US.

“There are so many circumstances in the life of a younger consumer where credit checks are required,” McClary says. “It's very difficult to work around the types of situations where your credit report may be a consideration.”

BNPL providers may report missed payments

Though BNPL providers may not report on-time payments, some still report missed payments.

For example, US-based Zip, previously Quadpay, doesn't report payments to the bureaus, but it will send past-due accounts to collections, which can affect your score.

Pamela Capalad, a US-based certified financial planner, said missed payments are the biggest risk when using a BNPL service. Because the instalments can be automatically billed to your debit card, you could overdraw your account, resulting in penalty fees, before ultimately defaulting on the loan. This can hurt at a time when you're particularly vulnerable.

People who use BNPL plans need to break up payments for one reason or another. To have that affect their credit, I don't think that's a good thing.

- Pamela Capalad

“Often the people who are using these types of plans need to break up the payments for one reason or another,” Capalad added. “To have that affect their credit at the same time, I don't think that's a good thing.”

McClary notes how one missed payment could also lead to costly financing in the future, since interest rates will likely increase for borrowers with lower credit scores.

“Once the debt collection account shows up on the credit report, it creates a more significant barrier to overcome,” he further noted. “The cost of borrowing goes up as your credit score goes down.”

Alternative ways to build credit

Both Capalad and McClary acknowledge that BNPL payment plans can be a valid way to budget for large purchases, particularly if the plan charges zero interest and you can make the payments. But if you're focused on building credit, it's best to look elsewhere.

A secured credit card is a smart alternative. It requires a cash security deposit, usually equal to your line of credit - a $300 (Dh1,100) deposit for a $300 (Dh1,100) spending limit, for example – and you don't need good credit to qualify. Once you're able to upgrade to an unsecured card, you'll receive your deposit back.

For those new to credit cards, experts recommends putting a small recurring expense on the card, like your Netflix subscription, and setting it to auto-pay. This approach allows you to use the card consistently without overspending.

Another option is a credit-builder loan. Unlike a traditional loan, you'll make payments first then receive the money. Payments are reported to the credit bureaus.

Additionally, applying for a smaller loan is also one of the easiest ways of improving your credit score and having a better credit history. The best way to go about it is to apply for a small cash loan of up to Dh5,000 and repay the loan amount in 6 months or a higher time period. If you have enough money to close your small loan, you can pay the loan amount in bulk but remember to not close the loan before the loan matures. This will quickly improve your credit score.

Loans are not simply meant for financial emergencies. If used effectively, they can act as a valuable tool for building credit scores. That being said, you have to understand your financial position before you apply for a loan and be very cautious regarding the payment of loan amounts. If you are not in a position to repay a loan, avoid falling into a debt trap as it will only cause damage to your credit score instead of improving it.

Always remember that a higher credit score brings with itself better financial options. By showing a history of responsible financial behaviour, you can build your credit profile and access more affordable financing in the future.