Installment plans have helped shoppers afford large purchases since the late 19th century and are still available for pricey items like cars and smartphones. But to delay payment for a T-shirt and a couple pairs of jeans, you needed a credit card. Now several fintech startups are putting smaller purchases on installment, too. 

Earlier this year, Australia’s Afterpay began offering installment plans in the U.S., joining Affirm, a San Francisco startup launched by PayPal co-founder Max Levchin. Square announced its own installments plan in October; so did Swedish payments company Klarna, which has teamed up with H&M to offer services in 14 markets it didn’t name.

Affirm and Afterpay say they’re targeting millennial shoppers by filling a gap between credit cards and store credit, which require lots of paperwork and a strong credit rating. Perhaps mindful of the new competition, established players such as Discover warn that these upstarts could run into trouble should the economy sour and defaults spike.

Consumers apply online or via app and learn whether they’ve been approved in seconds. They click a button at checkout on the websites of participating retailers if they want to pay by installment. Cotton On, which sells inexpensive apparel, began offering U.S. installments through Afterpay in August. E-commerce chief Brendan Sweeney says 20 per cent of buyers are already using the feature, which breaks up bills into four equal parts spread over six weeks and charges no interest.

“I was kind of skeptical that there would be a market for people interested in installments, but there clearly is,” he says. “We’ve seen a remarkable uptake from millennial customers.” Sweeney says shoppers spend US$50 on average per order.

Afterpay Touch Group Ltd. caught on quickly with Australian millennials, many of whom abandoned credit cards after the 2008 recession. Founder Nick Molnar was a teenager when the crisis hit and understood intuitively that his contemporaries would approach credit differently from their forebears.

The company charges no interest, instead collecting a fee of as much as 6 per cent of a sale from the retailer. Afterpay works with 20,000 merchants globally—including 1,000 now online in the U.S. where the company has signed up Urban Outfitters, Anthropologie and Free People. Based on its recent monthly performance, Afterpay says it has a global sales run rate of more than US$3 billion a year.

Afterpay is betting American millennials will be just as keen on its service as their Australian counterparts. The company says 65 per cent of the U.S. cohort don’t have a credit card, are 30 on average and are intrigued by using installments to pay for merchandise. Leslie Parrish, a senior analyst at researcher Aite Group, says the simplicity of installments is at the heart of the appeal. “You know precisely when you’ll pay off that loan,” she says. “That gives you more discipline.”

Affirm Inc. issued more than US$1 billion in loans last year, and expects to double that this year. Founded in 2012, the company says it works with more than 1,300 merchants including Peloton, Casper mattresses and travel giant Expedia. Affirm charges retailers a fee or consumers interest, which can be as much as 20 per cent. Repeat customers, who have shown they can repay loans, typically pay lower interest. Those who default may be turned away next time.

The upstarts are muscling into consumer finance even as traditional players pull back, citing the specter of rising defaults. Affirm and Afterpay typically approve more than 80 per cent of applicants, compared with about 50 per cent for store credit. Discover, one of the biggest players in consumer finance, has  zeroed in on offers from online lenders and warned that they lack the experience to manage through a downturn.

Afterpay and Affirm brush off such concerns, arguing that their technology analyzes hundreds of variables, even how fast a person is typing, to determine credit-worthiness.

“Their artificial intelligence and machine-learning algorithms is the secret sauce, allowing them to approve instantly a wider spectrum of borrowers not traditionally pursued by the legacy credit-card issuers,” says Richard Crone, who runs payments researcher Crone Consulting LLC.

The nascent industry is tiny and its proponents say there is plenty of room to grow in the U.S., where more than half of American consumers have lousy credit and need alternative ways to finance their purchases. Still hurdles are emerging. Despite building a US$1.8 billion business, Levchin acknowledges that most shoppers have no idea they’re using his company when they choose how to pay at checkout.

“We’ve built this enormous audience,” he says. “But a lot of them still don’t really know that much about us.” To become better known, Affirm in November said it was redesigning its logo and will start listing all the retailers it works with on its website. The company will also step up a focus on travel, letting consumers pay for vacations over time.

Afterpay has come under fire in Australia for late fees (US$8 if a borrower misses their second installment, for example) that made up about a fifth of its revenue in first half of the year. Critics say the practice could hurt consumers’ credit ratings, and the Australian Senate launched an inquiry into buy-now-pay-later businesses. The nation’s securities regulator, meanwhile, has asked lawmakers to tighten lending standards.

So far no such issues have emerged in the U.S., but consumer watchdogs are already paying attention. “These services were created to facilitate impulse shopping that, for many, jeopardize their ability to afford necessary expenditures and to build needed savings,” says Steve Brobeck, senior fellow at Consumer Federation of America.

Millennials, be forewarned.

--With assistance from Julie Verhage, Jennifer Surane and Matthew Burgess.