Wednesday, December 20, 2023

Spend now, panic later

As a Muslim, it is no secret that I am opposed to interest. At times, it has bothered me that interest is haram. Debt enables a range of financial transactions that, when leveraged correctly, are beneficial for the economy. When deployed improperly, they can be catastrophic, as we saw in the subprime lending crisis. But they can be beneficial for growing wealth. This was a phase I was in for a while when I was interested in real estate development. How could Muslims compete in real estate when their non-religious peers are ready to take out loans to fund bigger and better projects? I asked Sheikh Maun Qudah that question about a year ago. The answer is that we simply don't! As Muslims, we privilege our religion over the financial gain of more successful real estate transactions. 

Some things in Islam are things in Islam are things that we believe in without questioning. For example, there is no explanation for why pork is haram. There is an explanation for why alcohol is haram, or even gambling. "There is great evil in both, as well as some benefit for people," the Qur'an says (2:219). "But the evil outweighs the benefit.” This is straightforward. Interest is one of those more iffy things. Some people have made some arguments that actually, it is halal. These arguments are pretty easily debunkable. Interest is bad, though and there is a really good argument against it, despite it being financially and economically sound when properly used. 

I read this article in the NYT: "Americans May Be Taking On Too Much Pay-Later 'Phantom Debt.'" This is, more or less the exact thing that Islam warns about. The weird thing is though, that many of these Afterpay/Klarna/Affirm loans are interest-free! Pay-later companies claim to make their revenue off of fees to vendors. Vendors are inclined to pay fees because they have access to customers who otherwise would not buy goods or services. Obviously, missing payments means late fees. But a problem is that many of these short-term pay-later loans are not reported to credit bureaus, so the data on these things is challenging. 

Pay-later companies claim to be a better alternative to credit cards. Which is honestly a compelling statement. From experience, even as someone who pays off his cards every month, credit cards encourage spending higher amounts because of the way they hide spending from your bank account. People claim they like them more because they are more transparent:

“With a credit card, you can swipe it all day long and be like, ‘Wait, what did I just get myself into?’” Ms. Greco, a Denver resident, said. “Whereas with Affirm, it’s giving you these clear-cut numbers where you can see, ‘OK, this makes sense’ or ‘This doesn’t make sense.’”

I mean, that is a good point, I guess. These loans might be bad. The article spends a lot of time chronicling how they might be bad. The author does a poor job of comparing them to credit cards, which seem like the alternative that many people are choosing between. I would be interested to see what the adverse economic effect of credit cards looks like compared the adverse effects of pay-later schemes. 

The article compares the product to layaway, something that most disappeared in the 1980s after the widespread adoption of credit cards. Layaway had a brief revival in the early 2010s, but ultimately did not last very long. Companies offered low and zero interest loans. Layaway doesn't make sense on a store-by-store level. The costs of offering debt is high, and it makes much more sense to distribute it using one company that services many stores. That seems to be what companies like Affirm have done, enabled by the data collection powers of the internet. An interesting business model. Good for the economy? Maybe. Good for society? Unclear. 

Making bad financial decisions is not haram, I do not think. It is definitely bad though. My dad loves to repeat this quote: "people buy stuff they don't need with money they don't have." This is the case in many situations. At a car dealership, dealers ask you "what car payment would you like to have?" That's a silly question — simply being able to afford paying the monthly payment does not mean you can afford the car. A good rule of thumb for this is 20/4/10. You should be able to pay 20% of the purchase price up front right now. You should be able to finance the car over just 4 years. And the total money you are spending on the car should not exceed 10% of your income. This leads to funny situations: to buy a used car worth $20,000 with a 5% APR loan, you need an income of $80,000, which more than half of Americans do not have. But it is a good rule of thumb, precisely because it endorses financial prudence. 

The stats reported by pay-later companies don't paint them in a bad light.  2.4 percent of Affirm’s loans were delinquent by 30 days or longer, and this number is down from the year prior. Klarna says its global default rates are less than 1 percent. The credit card delinquency rate is only slightly worse, with the St. Louis Fed reporting that it is about 3% in the most recent quarter. The Consumer Financial Protection Bureau has little nice to say about buy now, pay later. From a report on the model:

This report explores the consumer financial profiles of Buy Now, Pay Later (BNPL) borrowers using the Bureau’s Making Ends Meet survey and its association with credit bureau data. While many BNPL borrowers who we observed used the product without any noticeable indications of financial stress, BNPL borrowers were, on average, much more likely to be highly indebted, revolve on their credit cards, have delinquencies in traditional credit products, and use high-interest financial services such as payday, pawn, and overdraft compared to non-BNPL borrowers. BNPL borrowers had higher credit card utilization rates and lower credit scores. However, many differences between BNPL borrowers and non-borrowers pre-date BNPL use. Further, contrary to the widespread misconception, BNPL borrowers generally have access to traditional forms of credit. In fact, they were more likely to borrow using credit and retail cards, personal loans, student debt, and auto loans compared to non-BNPL borrowers. Finally, the report estimates that a majority of BNPL borrowers would face credit card interest rates between 19 and 23 percent annually if they had chosen to make their purchase using a credit card. 

Well, this is awkward, at least a little bit. Pay later borrowers are more likely to be in debt and are just continuing older behavior. They are more likely to use other forms of credit. If they didn't use pay later, they would have to pay an insane average of 19-23% APR! For context, Klarna offers (for people with good credit) 6 month loans at 7%. 

Buy now pay later exacerbates bad habits. It might even be better for the economy, taking advantage of digitization to offer cheaper credit than credit card companies. It does highlight to me, however, that the bad of loans does outweigh the good.