Determining who to make loans to is one of the critical factors in the success of a dealer controlled financing business. Making the wrong decisions can cause you considerable collection work and expense than making good lending decisions. Poor BHPH underwriting can increase your delinquency, stunt your cash flow and trigger excessive charge-offs.
Good BHPH underwriting can help you avoid these mistakes, build your cash flow and minimize charge-offs. Effective underwriting can take many forms. Some dealers use a checklist to determine if a particular customer meets their minimum lending requirement. Others prefer an automated scoring process using such tools as AutoZoom or ProfitMax. The crucial element is to have a process with specific steps or criteria that you judge every prospective loan by.
No matter what process you use, there are 3 elements that must play an essential role in every underwriting decision. They are honesty, accuracy and ability to pay. Let’s take a look at each of these in more depth.
In many ways, our customers have been trained to lie in order to obtain financing. When they have applied for credit previously, they may have been turned down and told they could not get financed because their time at job or residence was too short or they didn’t make enough money. Naturally, the next time they apply for a loan, they expand their job and residence time and/or inflate their income in the hope that this will help them obtain financing. They may also leave out short time jobs or residences to appear more stable.
In dealer controlled financing, you need the customer to be honest and to give you accurate information. You must advise them early in the sales process that this is a critical component in getting a loan.
You must also have specific steps in your sales process for verifying the information the potential customer gives you to make sure they are being honest. Most BHPH and LHPH dealers I know collect pay check stubs to verify employment and some sort of documentation such as lease agreements or utility bills to verify residence. Many dealers also pull credit reports, not to check credit but to verify previous residence and job information, bankruptcy status and outstanding bills. Collecting reference names and phone numbers and speaking with these references are also important tools in verifying that the customer is being honest.
The information you collect must also be accurate. Information that is not accurate will not allow you to make intelligent lending decisions. One of the things I see most often when I conduct audits for dealers is one figure on the application for income but totally different numbers on the attached paycheck stubs. It appears as if someone just collected the stubs and put them in the file without ever checking that the income number the customer gave them, and that they used to calculate the customer’s debt-to-income ratio, is accurate.
I also often find paycheck stubs that are not the most recent ones that should have been available. Paycheck stubs are a snapshot in time. They are a strong indication that the customer was employed as of that date but may be inaccurate as quickly as the next day. That is why it is also very important to speak with the employer to verify continued employment.
I am also amazed that some dealers use gross income in their lending criteria. Your customer cannot spend gross income, they can only spend net. I actually saw one example recently where the customer claimed to make $800 every 2 weeks and the dealer used that figure to determine the customer’s ability to pay. However, if you looked at the paycheck stubs, you would see that the income after taxes was about $560 and that the customer had a wage garnishment and was repaying a loan from his employer. His actual check was for $156.
These kinds of mistakes caused by not studying the documentation supplied also apply to residence documents. In one audit I found that the utility bills supplied were for a different address than the one on the application but nobody had caught the discrepancy. In another case the customer’s insurance card was used to verify the address but it had expired 2 years earlier.
Basing your lending decision on bad information will have serious consequences for your dealership. You need to have policies and procedures in place to make sure you have complete and accurate information. Verification is critical to ensuring accuracy.
Ability to Pay
Last, but by no means least, you must be confident that the customer has the ability to make their loan payments. Verifying income is an important part of this equation but you must also know what your customer is currently spending. It is not uncommon for BHPH and LHPH customers to spend beyond their means. They will tell you, and fully believe, that they can afford your payment.
You need to collect information on what bills they are currently paying and make sure the added car payment will fit within their budget. It does you no good and creates additional expense to sell a vehicle to a customer who cannot afford the payment only to have to repossess it in a few short months when they do not pay.
This is the area where I see the most problems when I audit dealers. Some make a perfunctory list of bills the customer says they pay but do nothing with that information and some ignore this area entirely. You should get an honest and accurate list of a customer’s monthly expenses, allow for food & gas, compare that with their income and make sure they have enough disposable income to afford your payment. Failure to do so and making the loan anyway is a recipe for disaster for your dealership.
Making the decision on whom to loan money to is not rocket science but it does require some effort. Even with the best application and verification processes, you will not be right 100% of the time. However, being right 90% of the time is better than just following your gut and being right about 50% of the time.