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The Four C’s Of Buy Here-Pay Here Notes
Appeared September 2006 - volume 3 - issue 9 - page 20
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Buy Here-Pay Here is not a retail business in the purest sense of the word. Of course, there is a retail component. We sell cars to start the process, but no money is made at the time of sale. The money is made one payment at a time over an extended period. Our job is to maximize the chances of being paid over that long period. In order to achieve a high probability of repayment from high-risk customers, we must create loans that are collectible in the first place.
To maximize collectibility of these notes the four “Cs” must be in place. Those for “Cs” are capability, consistency, character and collateral. Without all four of these elements, loan success is doubtful.
We define capability as the customer’s ability to repay the loan. Without it, you are just renting cars. The customer must be employed, and that should be verified prior to vehicle delivery. This is easily accomplished by a phone call to the employer or by faxing a request for that information. This method works well, but times are changing.
Due to privacy laws, fewer and fewer employers are releasing this information for fear of legal liability. More and more dealers are using pay stubs as the proof of employment. This method is fine if you confirm the validity of a few items found on most pay stubs.
Those items include the name of the applicant, the correct social security number, a recent pay date, a pay-period amount as well as year-to-date information, and a calculation of typical weekly/bi-weekly or monthly NET pay. Yes, net pay!
That is part two of capability. The customer must have sufficient income to afford the car payment. This calculation is the responsibility of the dealer. Do not let the customer tell you what he or she can afford. I have yet to hear one say, “I can’t afford that payment.”
There are many ways to measure capability, such as doing complete budgets for the customers or debt-to-income ratios. One of the simplest and most-predictive calculations is a payment qualification percent. This method simply allows the customer a percent of the NET income that can be used for a car payment. The prudent number is 20 percent of net. I have witnessed dealers be successful up to 25 percent (if the customer makes decent money) but have not seen evidence that dealers do well above that 25 percent amount. When you add car payment, insurance, gas and maintenance to that equation, driving costs can easily exceed 50 percent of take home pay. That is simply too high.
The second element is consistency. This is a review of the customer’s stability in his or her life, both personal and professional. We can rate the customer’s stability by verifying time on the job, time in a residence, time in the market area and the number of local, personal references. These are not guarantees of good loans, but the lack of long-term jobs, stable homes and local references is a recipe for bad loans. When we review an applicant’s past, we sometimes place too much emphasis on history (ancient).
Some people’s lives are often in constant turmoil and change. The recent past is a much better indicator of predictability than what happened to the customer five years ago.
The third element is the most difficult to measure: character. We are looking to measure the character of the man or woman using our very limited knowledge, resources and time. If the average deal takes no longer than one to two hours, how well can we really get to know the customer? The answer is: not very well.
There are ways to get some knowledge and do so quickly. The first measurement is a comparison of the credit application to the public record, including credit bureaus, actual public records and Accurint type reports. These should match reasonably well. The second method to assess character is to ask the customer to review and explain prior credit issues. We look for customers who take responsibility for their past problems. We don’t judge them, but we are wary of people who blame the world for their problems.
Those who take no responsibility for their situations now will probably act the same way in the future. We also deny credit to anyone who comes on the lot with an attitude. A bad attitude on delivery day typically only gets worse. The best and simplest way to get a feel for a customer’s character is through an interview. A good interview can be the difference maker in approval decisions. After all, this is a people business.
The fourth element of a collectible loan is the collateral itself. We must never forget that if you put good people in bad cars the model doesn’t work. The tricky part is determining what is “good” collateral? The best answer I can give is to sell cars that are competitive in your market, that will run the length of the note with few repairs, and fit the income levels of your customers. I know, I know... this is easier said than done. That’s the rub, though. The hardest part of buy here-pay here is finding those cars! On the other hand, the great part of this business is that we can stop buying cars that don’t fit and move to ones that do.
If you are a Ford dealer, you have to sell Fords and if Fords aren’t selling, you can’t become a Chevy dealer. The most important thing to remember when purchasing inventory is that we are in a “needs” business and not a “wants” business. We are here to provide affordable transportation. Don’t buy cars that make you happy. First, buy cars thatsell, and second, buy cars that will pay out (that’s the ticket).
There is actually a fifth “C” element. That is collections. It’s actually the most important element, but by ensuring you have the first four in place, the collection process will be much more successful. We will discuss that in future articles. Collections are the backbone of the buy here-pay here business and can’t be summed up in a thousand words or less.