It's been a volatile year across nearly every asset class as investors focus on ongoing inflation and what the Federal Reserve will do to combat it.
In times of inflation, the Fed looks to raise interest rates to suppress demand and stifle increasing prices. These changes in interest rates have a ripple effect across markets, including the buy now, pay later (BNPL) industry. Firms in the industry face headwinds from rising borrowing costs -- here's what you should consider before investing in the industry.
Once-thriving BNPL firms have come back down to earth
Buy now, pay later options grew rapidly in recent years, driven by low borrowing costs and strong consumer demand for goods. The industry grew at an 85% compound annual growth rate from 2019 to 2021 as millennials and Generation Z customers turned to the low-interest rate installment plans.
Initially, a few big players dominated the industry, including Affirm (AFRM 1.83%), Afterpay, and Klarna. Affirm went public in early 2021 and reached a market capitalization of nearly $48 billion during the year. The stock has fallen back to orbit, sporting a valuation just north of $5 billion, down almost 90% from its peak. Klarna, the Swedish bank BNPL, has seen its private valuation cut from $46 billion last year to a rumored $30 billion during its most recent funding round, according to a Bloomberg report last month that cited anonymous sources. 
AFRM Market Cap data by YCharts
What higher interest rates mean for BNPL companies
The industry faces headwinds because of inflation and rising interest rates. In May, the consumer price index increased by 8.6% year over year, higher than economists expected.
BNPL lenders face two problems. One, Consumers may find inflation too much to handle, and could reduce spending on goods and services -- meaning fewer lending opportunities for BNPL firms. Second, rising interest rates could make it harder to fund these loans.
In order to combat inflation, the Federal Reserve is committed to raising interest rates. This year, the Fed has raised the federal funds rate from near zero to 0.75%. Analysts expect the federal funds rate to reach 3% to 3.25% by the midway point of 2023.
BNPL companies thrived when low interest rates ensured cheaper funding costs and plenty of cash to loan to consumers. However, BNPL companies rely heavily on borrowing to continue financing their business, and the cost of borrowing for these firms has increased significantly in the last year. For example, Klarna saw its borrowing costs rise to the highest on record. As borrowing costs increase, it will be harder for BNPL lenders to grow as quickly as they once did.
What I'm looking for before jumping into these stocks
BNPL firms are entering uncharted territory and face a test from rising interest rates and a possible slowdown in consumer spending. Companies with banking charters, like Block Inc., which owns Afterpay, and privately traded Klarna, could fare better because they have deposits that could fund their loans. Interest rates on customer deposits rise slower than the cost of debt, which could provide stability for the lenders. Earlier this year, Klarna told Bloomberg that 80% to 85% of its loans are funded from customer deposits.
Companies without a bank charter, like Affirm, could struggle as their funding costs increase, compressing the business's margins.
The industry faces other headwinds too, including Apple's entry into the space and increasing regulatory scrutiny. For this reason, I'm avoiding investments here in the near future. Still, I'll be keeping an eye on interest rates and consumer delinquencies for those like Affirm and Block, Inc. over the next few quarters and will reevaluate.
