Explainer: How Lending Startups Like Afterpay Make Their Money
Saurav Dutta, 8 Dec 17
       

Afterpay uses a model that has been around for centuries. AAP

Startups like Afterpay that allow consumers to “instantly” borrow money for purchases are using a business model that has been around for centuries

It’s called “factoring” of accounts receivables. This is when a company sells its accounts receivables (money owed for a good or service that has already been delivered) to a lender, typically at a discount.

Typically, factoring arrangements are between a business and a lender, with the customer being oblivious to the arrangement. Afterpay’s innovation was to turn this centuries-old, back-office financial arrangement into something customer-facing.

In 2016-17, Afterpay generated about A$23 million in fees from retailers and another A$6.1 million in late fees. It wrote off only A$3.3 million in bad debt.

An example of traditional factoring would be a company selling A$100 in accounts receivables to a lender for A$95. The company gets A$95 cash up front (to spend on wages or ingredients) and eliminates the risk of not being paid. The lender makes a A$5 profit once the A$100 has been collected.

Similarly, if you make a A$100 purchase using Afterpay, the merchant immediately receives A$96. Afterpay then collects four instalments of A$25 from the customer, making a A$4 profit.

The A$4 difference is essentially the interest that Afterpay charges (equivalent to 4.17%). The unusual nature of the transaction is that Afterpay lends to the business and the customer repays Afterpay.

The 4.17% Afterpay charges in this example is quite a modest interest rate, at least compared to credit cards. However, since each loan is outstanding for only a short time, generally six to eight weeks, or a maximum of two months, Afterpay can earn much more than 4.17%.

This is because of compounding interest. Suppose a A$1,000 loan is made on January 1 at an interest rate of 4%, for two months. On March 1, A$1,040 is collected – the original A$1,000 plus A$40 interest.

Another loan is made on March 1 – A$1,040 at a 4% rate, for two months. On May 1, A$1,081.60 is collected – the original A$1,040 plus A$41.60 interest.

This can be repeated again and again. By December 31 the initial A$1,000 has grown to A$1,265.32. This equates to a 26.5% annual interest rate.

Except Afterpay doesn’t have to wait two months to collect the entire amount as a lump sum. Instead, it collects the money lent in instalments, which means the the annual interest rate is approximately 30%!

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