The sales concept of "buy now, pay later" is quickly growing in popularity among online shoppers. Instead of putting a purchase on a credit card, which charges high interest rates with no predetermined loan term, shoppers can sign up for a set number of installments for big purchases, often with no interest charges.

PayPal (PYPL -1.68%) started rolling out its buy now, pay later feature in August last year, in an effort to take on start-ups in the space like Affirm (AFRM -0.91%), Klarna, and Afterpay. While PayPal may have gotten a bit of a late start, buy now, pay later remains a big opportunity for the fintech company. Here are three reasons why.

PayPal logo in the courtyard of an office complex.

Image source: PayPal.

1. PayPal is well-positioned to win in a rapidly growing market

Online purchases in the U.S. made using a buy now, pay later service increased 215% year over year in January and February, according to data from Adobe. The market is growing rapidly as more retailers offer the option, and consumers find it appealing amid economic uncertainty.

That said, the competition is crowded. Not only is PayPal competing against other buy now, pay later companies like Affirm, it's also competing against more traditional forms of payment like credit and debit cards, as well as other digital wallets. 

Affirm, which recently completed its IPO, has established a strong position as a leader in the markets and key strategic retail partnerships, including Peloton and Shopify. But its business is still relatively concentrated. Roughly 27% of its revenue came from Peloton during the second half of 2020.

PayPal's advantage is that it already has an existing network of 29 million merchants. It can offer customers who choose PayPal at checkout for those merchants the option to pay in installments. It can then bring data on those checkouts to merchants and show them the value of buy now, pay later, in an effort to get the PayPal installment option displayed further up in the sales funnel.

While there's room for multiple winners in buy now, pay later, PayPal is better positioned than most of its competitors to grow its share of the rapidly expanding market.

2. An opportunity to grow payment volume

Offering buy now, pay later has a noticeable effect on retailers' sales. 

The average cart size for a checkout using buy, now pay later is 18% larger than for orders the consumer pays for upfront. This makes sense since it's kind of impractical to use an installment loan to pay for a $50 online grocery order. But it also means that buy now, pay later can make expensive items feel more affordable for consumers.

That's evidenced in increased conversion rates. Klarna says its retail partners see a 30% increase in sales conversions when they adopt its service. Affirm says conversions improve by 20%. PayPal hasn't disclosed any data on improved conversions, but management says it's seeing improved conversion rates among early adopters of its buy now, pay later service.

The combination of higher average order size and better conversion rates will result in more total payment volume for PayPal if it successfully takes share of the buy now, pay later market. That's key since it's not monetizing the service through interest payments or many fees.

3. Lower transaction costs

One interesting characteristic of buy now, pay later shoppers is how they choose to pay back their installment loans. "The vast majority of that volume is debit funded," VP of Finance & Analytics Erica Gessert said in a follow-up call to PayPal's fourth-quarter earnings.

Debit and bank-funded transactions are less expensive for PayPal than credit card transactions.

While PayPal supports repaying its installment loans with credit cards, consumers are more likely to choose the option at checkout if they're averse to credit card transactions. Credit card transactions fell sharply during the pandemic in favor of debit card payments. Meanwhile, younger consumers, to whom fintech companies like PayPal and Affirm are most appealing, are generally more reluctant to use credit cards.

So, as buy now, pay later becomes a bigger piece of PayPal's total payment volume, it should see its average transaction cost decline. That means better profit margins.

PayPal may have gotten a late start with buy now, pay later, but it's not too late. There's still a massive opportunity for it to grow total payment volume and margin for years to come.