There is an ancient Indian parable about a group of blind men describing an elephant.
Each touches a different part of the creature and makes different conclusions. To the man who feels the trunk, the elephant is like a large snake; to the man who feels the tusk, it is like a spear; to the man at the ear, a fan, etc.
Customer financing can sometimes seem like this …
For some, it’s a powerful tool and an essential ingredient for growth. Furthermore, if your competitors offer customer financing, do you have a choice not to?
To others, it’s a risky strategy that should be used with caution or avoided altogether. If your business is going well, are the gains worth the fees that could be involved?
Take perhaps the best-known form of customer financing right now: buy now, pay later (BNPL).
Some advocates claim that BNPL is a revolutionary innovation and net positive for customers and businesses. While others believe it’s unsustainable and dubious. One Harvard researcher recently claimed it “has the potential to be a pretty big bubble.”
In this article, we will look deeper into these questions to build a comprehensive view of customer financing.
What is customer financing?
Customer financing is a payment method (or payment plan) that enables your customers to buy goods immediately but pay for them later.
There is variation between customer financing options. The differences between solutions generally revolve around the following:
- Installment time periods
- Interest rates (or lack thereof)
How does customer financing work?
Customer financing is provided directly to customers by the business itself or by a third-party financing provider.
In the latter cases, the store or service provider also receives their payment immediately but pays a transaction fee to the financing provider. There may be interest applied to the payment, depending on the solution and provider you choose.
SMBs generally use a third-party financing company. But larger enterprise often work with third parties as well.
Setting up in-house financing operations may be cost-efficient in the long term. But they require a big investment in resources.
As well as hiring staff to manage the financing operations, you will need to implement processes that meet regulatory compliance standards.
Specialist technology and automation will also need to be integrated with your systems so the process of applying for and using the credit can take place seamlessly between you and your client.
How do customer financing providers make their money?
Customer financing providers generally make their money in four main ways:
1. Interest rates
Interest fees are a common feature across many kinds of financing options. They enable lenders to make a profit and create cash flow so they can take on new customers.
Offering customer financing to your customers often means the interest fee is between the provider and customer, not your company.
However, not all customer financing solutions charge them (see below, ‘Buy now, pay later’ section).
2. Transaction fees
Customer financing providers usually charge their clients each time the client’s customers make a purchase. With buy now, pay later, for example, this fee is usually between 2-8% of the purchase total.
Providers argue that this charge is more than compensated by the benefits customer financing offers (see below, ‘advantages of customer financing’).
3. Data sales
Data privacy is a hotly debated subject in both the media and political institutions.
At present, the selling, storing and use of data is still a relatively opaque field. However, it is safe to say that many customer financing providers are likely involved in it.
As new regulations emerge and transparency increases, it may impact how companies operate in this field. The outcome should be more market share for the most ethical players.
4. Fines and debt collection-related charges
Most customer financing solutions charge customers who fail to pay back on time. This obviously impacts their own bottom line.
Perhaps it has never been put more starkly than when Klarna co-founder and deputy CEO Niklas Adalberth said to an audience in 2013:
“[debt collection is] one of our revenue streams. The best customer is the one that doesn’t pay directly, but actually gets a reminder and then also a debt collection letter, because we’re able to add the legal fees – state-controlled fees in that specific country. So yes, we are our own debt collection firm as well, and we do that during [sic] a different brand, it’s called [Segura?] so [as] to not ruin our own brand.”
However, this issue should always be viewed in context. Late and unpaid payments can destroy businesses. They disrupt cash flow, which has a knock-on effect on operations.
This of course doesn’t rule out the possibility that some financing companies may be excessively encouraging unsuitable businesses to offer customer financing.
As with data sales, this is another area where transparency and regulation will likely advance.
Different types of customer financing
As we will explain, customer financing existed long before fintech. But the continuing rise of fintech over recent years is good for B2B sellers as it means more choice.
New third-party financing companies are emerging all the time. They often target increasingly specialized niches.
One of the main ways they compete for market share is by trying to offer better rates and a more frictionless experience (see below, ‘Embedded financing’).
Here are a few different types of customer financing.
Layaway payments first appeared during the great depression of the 1930s.
Its popularity waned in the mid-80s (when credit cards become more popular), but they can still be found in some places, mostly brick-and-mortar stores.
They allow customers to put down a deposit against the total amount of a product’s value. The customer then pays off the rest of the remaining value in the coming weeks or months.
They don’t receive the product until the whole amount has been paid. In effect, the store has laid away the product for them until they have fully purchased it.
Store credit cards
There are three main differences between store credit cards and regular credit cards.
1. Interest rates
Store credit cards often charge higher interest rates than credit cards. Both charge late payment fees.
2. Location use
Unlike credit cards, which can be used almost anywhere, store credit cards can only be used in that store (including in other locations for chain stores).
3. In-store discounts
Store credit cards often come with discounts for goods and services bought in that store. Credit cards may work with other companies for promotions, but these are usually more fragmented and temporary in nature.
Other than these three differences, the two are quite similar. They both require credit checks before customers are approved, for example.
Point-of-sale (POS) financing
POS financing means financing that is offered at online or physical checkouts.
Technically, store credit cards are often offered here, too. However, unlike store credit cards, POS financing generally doesn’t require credit checks and a sign-up process.
Buy now, pay later
Buy now, pay later is probably the most well-known type of POS financing. It has exploded in popularity in recent years.
It is a short-term customer financing option that enables customers to receive products immediately and pay for them in installments.
It is usually interest-free. However, many providers charge for late payments.
BNPL has gained popularity rapidly over the past couple of years as a consumer offering. It has prompted companies to think more seriously about bringing similar levels of choice and convenience to B2B buyers.
Providers such as Klarna, Affirm, PayPal and Clearpay have made headlines with their huge growth in recent years. Apple Pay has also recently announced it is moving into this field.
BNPL doesn’t require credit checks in the way store or regular credit cards do. And its marketing often reflects its accessibility and simplicity.
Some critics have complained that it leads some customers into debt, especially with younger people, with whom it is most popular. One study found that 71% of Generation Z respondents had used BNPL for buying clothes.
Stricter regulation for BNPL in the consumer space has been discussed a lot in recent years and some is moving into place already. Many providers have said that they welcome it.
What’s the difference between customer financing and consumer financing?
Customer financing and consumer financing are often used interchangeably, but there is arguably a subtle difference between them.
Customer financing often specifically refers to the practice of businesses providing it to their customers. It is used within industry-focused discussions.
Consumer financing generally refers to the practice more generally. It is often used in the context of discussions around economics and business more broadly.
Furthermore, a consumer, strictly speaking, is someone who uses a product or service, which is not always the same as someone who directly purchases it (a customer).
We’ll leave any more hair-splitting over the precise differences to another day! In the meantime, awareness of common usage and interchangeability between the terms is enough.
A brief history of customer financing
Versions of customer financing have been around for centuries. In Financing the American Dream, Lendol Calder states:
“Credit for consumer goods is the oldest of all forms of credit, with a history stretching back to antiquity. But the modern system of credit for consumption has its roots in the two decades after 1915.”
“Early prototypes of credit cards also appeared during this period. The first was the Charga-Plate, an aluminium plate and paper combination that was mostly issued by large merchants to customers, developed in 1928.”
“Initially, customer financing was used for bigger purchases, such as cars and relatively expensive household items. Later on, it spread to other items, including retail.”
The rise of eCommerce brought its own financing boom. And new fintech players have helped develop this further with innovations such as embedded finance (see below, ‘Embedded financing’ section).
Is customer financing a good or a bad thing?
This question is often asked in an ethical context. Some believe customer financing may lead to the exploitation of consumers who end up paying more (because of interest or late fees) or even in some cases ending up in debt.
Customer financing is also sometimes blamed for encouraging irresponsible consumerism which contributes to broader economic instability.
Calder further argues that it actually encourages the opposite behavior:
The kind of discipline enforced by installment credit involves the renunciation of many small desires for the purpose of enjoying a few expensive ones. It preserves the relevance of old ideals such as thrift, frugality, and planning….
Alternatively, customer financing can be seen in the light of behavioral psychology. In essence, decisions customers make around financing their purchases might not be as sophisticated as Calder – or we ourselves – think:
We think, each of us, that we’re much more rational than we are. And we think that we make our decisions because we have good reasons to make them. Even when it’s the other way around. We believe in the reasons, because we’ve already made the decision. – Daniel Kahneman
Whether customer financing is primarily about making goods and services more accessible or whether it’s encouraging them to spend beyond their means is a subject that will be debated for a long time yet.
Opinions vary, as does the quality of financing providers and the types of financing on offer.
Advantages and disadvantages of customer financing
The below advantages and disadvantages of customer financing are from the point of view of business owners.
The benefits of customer financing often relate to increased sales and improved customer experience. A lot of other benefits come downstream of these.
Let’s look more closely at these advantages.
1. Increase conversion rates & sales
Customer financing is generally seen as a consistent way to increase sales and conversion rates. Exactly how much it increases spend varies according to several factors, including: industry, season and specific provider.
For example, according to one study, offering buy now, pay later increases sales in fashion for female customers by 51%.
2. Increase average order value (AOV)
According to Klarna, retailers that use BNPL see an AOV increase of an incredible 45%. This can obviously make a huge difference to the growth of a businesses.
As with sales more generally, these figures vary across industries and between companies.
3. Increase customer loyalty
A big part of the appeal of customer financing is the convenience it offers. The positive associations this brings in the customer’s mind can have a knock-on effect of increasing customer loyalty.
Many business owners are also aware that if you don’t offer financing to your customers, they might simply go to your competitors who do.
Loyal customers are also likely to better customers. Their satisfaction with their first purchase is obviously an important starting point for trust. One report found that repeat customers also spend 67% more than new customers.
4. Increase range of customers
By effectively making your products and services easier to access, customer financing can bring you customers from outside your core target audience.
This can open up new revenue streams and business possibilities. This trend is often seen in retail, particularly when high-end fashion goes mainstream.
5. Improve cash flow
By offering financing to your customers via a third party, you receive the full payment of the purchases upfront (minus the transaction fee).
This improves your cash flow, which you can then invest elsewhere in your business. This benefit is especially helpful to small businesses, presuming they can comfortably meet the requirements of the financing program they use (such as minimum sales figures).
Like all financing options, customer financing has some potential downsides. Below we have listed three of them.
- Scaling costs
The timing of when you deploy customer financing is important.
If you achieve increased sales, higher AOV, new customers, etc., you may find that you put stress on your resources, including supply lines and cash flow.
Scaling up before you have the right infrastructure in place can damage your reputation. Of course, you can’t be certain how much customer financing will improve your sales. But the best-case scenario could become your worst-case scenario if you aren’t prepared for it.
In order to offer customer financing, you need to pay your customer financing provider. Some of these rates can be highly variable.
This can be a concern for small businesses, particularly if you work in an area where financing isn’t traditionally popular.
Simply put, you need to weigh the costs to your business with the increased sales offering financing could bring vs if it doesn’t succeed.
Credit checks are relatively simple – and some would say less secure – for a lot of customer financing options.
What happens when customers default on their payments? Always read the fine print of contracts and understand all potential outcomes before signing anything.
How to offer customer financing
Obviously offering financing (using your own in-house processes) is something that requires a lot of research. However, finding a financing provider should be more straightforward.
Which type of customer financing should you offer?
Asking your customers directly is one way to help decide a route, as is looking at what your competitors are offering.
One benefit of finding the right supplier is the advice and expertise that comes with their service. This isn’t always easy to work out beforehand. But it can be helped by reading reviews and speaking to existing users of services, if possible.
Knowing precisely which parts of the process your supplier helps with is also crucial. Issues such as POS integration and where you market your new offer need to be considered.
Embedded finance is the seamless integration of financial services by non-financial players.
It’s one of the key components you need to get right if you want to effectively implement customer financing.
Like embedded payments, embedded finance has become an expectation of many customers. The reality is embedded finance requires complicated technology and processes. Approval decisions need to take place in seconds if you don’t want to lose customers at checkout.
People working in business-to-business (B2B) industries are increasingly expecting business-to-customer (B2C) levels of service.
In short, they are also expecting choice, convenience and a frictionless experience at checkout.
The metrics and processes of B2B financing are quite different from those in B2C.
More decision-makers may be required to approve larger purchases with longer payment terms. And higher purchase prices/longer payment terms also need to be considered.
You are likely to find that your larger clients will have more complex requirements in terms of invoicing hierarchy and spending controls.
Which type of financing is offered to B2B clients is also different. Invoice financing (including factoring and discounting), lines of credit and other solutions are available.
An increasing number of B2B customers are now expecting the same kind of payment options and convenience as consumers at the point of sale.
Customer financing has been around for a long time, but in its modern incarnation, its roots lie in the early 20th century.
Like many forms of financing, and economics more generally, there has long been debate over best practices, regulation and whether it is essentially a good or a bad thing.
It’s useful for you, as a business owner, to be aware of these issues. But the bottom line is usually a more pressing concern. If your competitors offer financing, it’s often not a question of whether you should too, but choosing the right way to do it.
The main disadvantage is that there are some costs and risks involved. You may not have the upfront investment and time to do it in-house.
Chances are, however, that you will want to reap the benefits more quickly and so a third party could deliver a customer financing solution, integrate it and ensure it is compliant with rules and regulations. Finding a provider that specializes in your industry is often crucial.
Buy now pay later for consumers has raised the stakes for payment convenience and choice but savvy B2B sellers are seeing an opportunity to differentiate themselves with similar propositions for their buyers.