So much to buy, many ways to pay

The challenge for consumers and merchants alike is to understand where the value and costs lie in each of these systems.

For example, a traditional home loan is a classic pay-later credit product - the lender funds the purchase and the borrower pays it back over some years. Because of the size of the purchase most people don’t have the funds on hand to “pay now” even if they wanted to. In return the lender charges an interest rate for making the loan available and to cover the risk the money might not be paid back.

For a much smaller value purchase like the high-tech television, maybe we do have the funds available. Or maybe we’ve been given a gift card or have enough reward points from an airline frequent flyer program.

When we do have such choice it becomes a case-by-case decision whether to pay before, now or later. That’s why it’s worth understanding where the costs and revenues are in each system.

Burden of choice

While pay-before is typically free to use, the cost comes from pre-committing your funds. If you have paid for a gift card that means funds are no longer in a term deposit earning interest or are not being used to make an extra payment on the home loan. That’s a cost.

It’s easy to forget that cost applies to cash too. Cash in your purse is actually dormant, it’s not earning anything, paying off anything or buying anything when it’s “just cash”. (Indeed any inflation will actually erode its value.)

The issuers of gift cards also enjoy two key sources of revenue: they earn interest on the money sitting on the card before it is used (the “float”); and they never have to pay the amount, estimated at around 10 per cent of the face value of cards, which is never used - either because someone forgot there was money left on the card or they lost it (known as “breakage”).

There is also the risk the pre-paid card or voucher might expire or - unfortunately not uncommon - the business which sold the card goes bankrupt and the cards are no longer honoured. (Legally, as the owner of the gift card you are an “unsecured creditor”.)

Those who operate pay-now schemes like eftpos or NPP make their money from various fees. These may be network fees or usage charges or what are known as “interchange” fees.

Because payments are network-based they typically involve an institution issuing a payment instrument on behalf of the customer (maybe a card or NPP account), a network provider (like NPP or Visa or MasterCard or Alipay) and an institution processing the transaction on behalf of the merchant.

That all of these parties have costs and receive benefits makes the pricing of transactions so complex no one has ever agreed on what they should be. At some point, however, they will be built into product prices and other fees.

“Pay later” is in essence unsecured personal lending. A credit card is a guarantee you can borrow money to buy things up to a limit and you don’t have to get special approval each time. The issuer of the card - the lender - makes money from either fees or interest rates or both. Fees are also charged to merchants who accept the cards, usually between 1 and 2 percentage points.

The increasingly popular pay later schemes, like Afterpay in Australia, are a variation on unsecured lending. Each transaction is discrete and the provider makes money mainly from the merchant – charges are more than double credit card merchant fees – and there are also charges to consumers if the loan is not paid back in the agreed time and sometimes other charges like establishment fees.

Sometimes these schemes are described as modern lay-by but they actually have more in common with hire-purchase. In lay-by, while you pay in instalments, you don’t take possession of the good until it is fully paid off. With hire purchase you take the good immediately and pay it off in instalments – but either at a higher price or with an interest rate.

Store credit is not dissimilar – it is “zero interest rate” as long as the loan is paid off in the agreed time.

Circumstantial

For us consumers, which system to use will depend on the situation and our personal circumstances. Maybe we don’t have the money so pay later is the only feasible answer or maybe we’re very disciplined in paying off credit cards so we’re happy to use the card in the knowledge we’ll get reward points and won’t pay interest.

But maybe we’re not so disciplined so debit or eftpos makes more sense - we can only spend what we have. Or for a present or sending a family member overseas a pre-paid gift card or travel card may make sense.

For merchants, it’s not straight forward either. Most larger or more sophisticated merchants want the consumer to be able to use whatever payment they like at no extra cost. That’s because their best interest is in making the sale, not annoying or surcharging customers.

(And they know cash is not free – it has handling costs, security costs and needs to be banked before it has value.)

Payment systems do have costs – and their calculation isn’t simple. For example, eftpos interchange is lower than credit card interchange but for the consumers a flat rate charge gets more expensive as the price decreases while if a charge rises with value – ad valorum – costs rise with price . Merchants are prepared to pay much higher fees for pay-later schemes for the moment because these schemes are very popular with younger buyers.

Although it’s worth remembering when credit and charge cards were first introduced, merchant services fees were more than 10 per cent – as time progressed merchants became more discriminating in understanding the cost to sales equation while card issuers became more efficient and better at managing fraud.

The key point is the method of payment is always a balance of personal needs, choice and merchant.

No one method is inherently better. None are free.

Andrew Cornell is Managing Editor of bluenotes