Facebook (META -2.70%) quietly rolled out payments in Instagram to some users at the beginning of the month. The payments feature asks for users to input their credit or debit card information once, and then it can be used to pay for products or services advertised on Instagram. The feature currently only works for booking appointments, but it could quickly expand to more businesses, especially with the rollout of Shoppable Ads on Instagram.

Payments on Instagram could be a significant threat to digital payments processors like PayPal (PYPL 0.47%), which have greatly benefited from the growth of mobile commerce in recent years. Facebook could easily provide a better experience and better pricing for businesses advertising on Instagram than PayPal. And considering the amount of time spent and product discovery on Instagram, it could be a very meaningful product for both Facebook and PayPal.

Close up of hand holding phone with Instagram loaded.

Image source: Facebook.

Facebook's payments philosophy

Analysts asked Facebook's management several questions about payments across its apps during the company's first-quarter earnings call. CEO Mark Zuckerberg noted that it's not trying to make money off of payments in and of itself. "In general, our strategy is to offer those services at cost, and make it so that businesses can bid what it is worth to them to run ads in the system," he told analysts.

Basically, Facebook sees payments as a way to add more value to its advertising business. If a business can convert leads from ads into customers faster and more easily, it's going to pay more for an advertisement. It's all about improving the return on investment for marketers.

Facebook is increasingly focused on improving the return for marketers after coming up against ad inventory limits. Year-over-year ad impression growth lagged user growth in each of the last three quarters. Nonetheless, Facebook is able to grow revenue through significant increases in average ad price. And the average ad price is driven by providing better value to advertisers.

So, if adding payments can get users to respond to advertisements better, Facebook could only charge businesses its own costs, or even give away payment processing. It can then offset those costs by increasing average ad price. That's a huge advantage over traditional payment processors.

It's also worth noting that Facebook's ad auction will encourage more businesses to work to process transactions within Instagram than with a third-party on their own website. That's because the auction will force ad prices higher as at least some businesses gain value from payments on Instagram. That will leave others paying a premium even if they don't use payments, thus moving them toward taking advantage of the service. That can be a virtuous cycle for Facebook, but it comes at the expense of competitors like PayPal.

Keeping users on Instagram

Another benefit of payments on Instagram is that it will keep users in the app if the entire transaction can take place in Instagram. "That's going to make people's experience better, so that way we can just do that in line," Zuckerberg said.

Users already spend a lot of time on Instagram. Those under 25 average over 32 minutes per day, and those over 25 average 24 minutes per day. Creating a smooth in-line transaction process for products discovered in the app could get them spending more time in the app instead of going somewhere else to learn more about whatever they find. That means more opportunities to show ads in Instagram.

Instagram is an increasingly important part of Facebook's total business. Increasing ad value and engagement through payments could add further fuel to the growth of Instagram over the next few years. And the fact that Facebook doesn't plan to generate any profits from payments directly makes it a serious consideration for PayPal and digital payments companies.