As point-of-sale installment payments become more prevalent in the United States, it is worth examining the various models for installment payments and understanding how installments in international markets have evolved. When evaluating installment payment programs, it is important to understand the costs and benefits for all stakeholders, including consumers, merchants, and banks.
Fundamentals of Installment Payments
Installment payments are a credit offering that allow customers to purchase an item by agreeing to make a set number of payments over a set period of time (e.g., 6 monthly payments, 12 bi-monthly payments, or 26 weekly payments). Unlike layaway which requires the balance be fully paid before merchandise leaves the store, installments allow the customer to take their purchase home that day. Also in contrast to layaway, where there is no credit risk or risk of a consumer not being able to participate in the program, installments do involve a credit risk and consumer credit decisions. In some instances, the merchant bears the credit risk of the installment loan (e.g., Rent-a-Center), but in most cases the credit risk is borne by a third party finance company or bank.
A traditional installment loan is different from a credit card. While an installment applies to a specific purchase over a defined period of time, a credit card is an open line of credit that can be used for multiple purchases without a well-defined repayment period. Once a customer repays a specific purchase via an installment loan, their obligation is complete and if they want to make another purchase, they must arrange a new installment loan. For a credit card, as the customer pays down their balance, they increase their available credit line that can be used to make additional purchases.
Technology and innovation have started to blur the line between credit cards and installments. Traditionally, installment payments were targeted towards customers living paycheck-to-paycheck, to help them make large purchases but have the expense spread out to match their income stream. Customers who utilize installments oftentimes would not qualify for a credit card and have no alternatives for funding large purchases. However as installments are introduced for consumers using credit cards, these cardholders, by definition, have a source of credit, and installments provide an opportunity for cardholders to manage their interest expense and credit line.
Models for Installment Payments
While there are a variety of different implementations of installments, there are two primary models: customer-funded installments and merchant-funded installments. Each model offers risks and opportunities so it is important to understand each one.
Customer-funded installments are defined as the customer paying the interest expense as part of the installment payment. For example, a customer could purchase a $600 television for 6 monthly payments of $110 (the total payment of $660 represents an APR of 20%). If the merchant is using a bank or a finance company to cover the credit risk, then the merchant bears no risk of non-payment by the customer. Customer-funded installments can be offered by fin-tech companies (e.g., Affirm) or by financial institutions (e.g., Plan It by American Express or Blueprint by Chase).
Merchant-funded installments are defined as the merchant paying the interest expense or delaying settlement until the payment is received. In this example, a customer could purchase a $600 television for 6 monthly payments of $100 (the total payments of $600 represent 0% interest). Merchant-funded installments are typically advertised as “X months with no interest.” If the merchant is using a bank or finance company to cover the credit risk, then the merchant bears no risk for non-payment by the customer, but the merchant would pay the installment loan provider a fee to cover the risk of repayment as well as cost of funds.
When merchant-funded installments intersect with credit cards, merchants offer cardholders a short-term loan at 0% interest that also earns points, miles or cash back. It is completely rational that cardholders would choose to participate, but this creates financial pressure on the merchant. When a customer makes a credit card purchase without installments, the retailer receives the full purchase amount (less any applicable credit card acceptance fees) the following day. Typically, when a customer makes a credit card purchase with installments, if the customer selects 12 installments, the retailer would receive 1/12th of the purchase amount (less any applicable credit card acceptance fees) each month across the twelve-month period.
Clearly, being paid over a period of twelve months, as opposed to being paid the following day has a serious effect on a merchant’s cash flow and working capital. Any merchant that pays for their inventory in advance but does not receive the full proceeds of a sale for several months will find their cash reserves under tremendous strain as they try to maintain inventory levels.
Because of this impact to the cash flow, many banks also offer settlement acceleration services that allow the merchant to receive their installment settlement the next day, just like their non-installment credit card purchases. However, the fee for the acceleration service can reach almost 20% and are in addition to interchange expenses 1.
Installments in Mexico
Although there are similar programs in a number of international markets, the evolution of installment loans in Mexico demonstrate how a merchant’s operating expenses can increase over time.
In Mexico, only the top 10% of the population in that market qualifies for a credit card, so there is need among the remaining 90% for access to credit to fund larger purchases. Merchants introduced installment loans as a way of helping these customers make large-ticket purchases. Since the 1950’s, Mexican retailers Coppel and Elektra based their entire business model on installments, offering their customers a wide range of appliances, electronics, furniture or other home items by making weekly, biweekly or monthly installment payments. Initially, Coppel and Elektra were not banks and they were prohibited from charging interest, so instead they just increased the price of their merchandise and allowed their customers to pay back their purchases in equal “no interest” installments. This drove sales, but also increased traffic as customers regularly returned to the stores to make their installment payments. However, if a customer missed a few installment payments, an agent from Elektra or Coppel would show up at the consumer’s home to collect payment or reclaim their merchandise.
Credit card installments were introduced in Mexico in response to what customers were seeing in advertisements from Coppel and Elektra. Now, credit cardholders who shopped at other merchants could also get 3 months no interest installments. These initial installment promotions were exclusive to specific banks and merchants, meaning they may only be available to cardholders of one specific bank shopping at one specific merchant. Initially these promotions were funded by the participating banks. When it became evident these programs drove sales, other banks were quick to start offering similar installment promotions and merchants began asking to participate. In fact, merchants were willing to pay to participate in the installments which triggered an inflection point in the market as merchants rushed towards installment promotions.
“Meses sin intereses” (Spanish for “months without interest”) promotions are now frequent across most merchants in Mexico, and it is not uncommon for merchants to have up to ten promotions running at the same time. These installment promotions may vary by issuing bank (e.g., Banamex cardholders might get 6 months no interest while Bancomer cardholders get 12 months no interest). Some promotions will apply to everything in the store, while other installment promotions may be specific to categories (e.g., 18 months on all televisions) or specific to SKUs (e.g., 18 months on a 55-inch Samsung television). With broad promotions, customers in Mexico may even use installments through their credit cards to purchase small items, such as a gallon of milk, and pay for that milk over 3 monthly installments without interest.
Implications
Installment programs have traditionally been an avenue for consumers with limited or no access to traditional credit programs to be able to afford large purchases. However, installments on credit card transactions (especially if merchant-funded) start to create significant expenses on top of interchange for merchants.
Merchants should evaluate installment programs carefully to determine impacts on their business: providing greater access to credit for a broader base of customers; potential acceleration of sales; balance sheet (cash flow impacts if funding occurs only as consumers are charged the monthly installment); impacts on expenses (accelerating settlement; increased borrowing expenses); and impacts to consumer prices (pricing of goods may include assumption of expenses to offset additional installment expenses).
1 https://www.mercadopago.com.mx/ayuda/mensualidades-sin-intereses_2255