Underwriting Guidelines 101

The tightening of the credit market has turned many traditional auto retailers’ eyes toward buy here pay here as an attractive option to consider as a supplement, maybe even an alternative, to their retail business. However, those dealers often have the misguided impression that running a BHPH lot is not much different than running a traditional retail lot. As anyone who’s been in BHPH for a while can attest, the focus is not on how to sell a car; the focus is on determining who to risk selling a car to—in a word, underwriting.

Working in a traditional retail dealership does require some assessing of customers’ creditworthiness; however, the actual underwriting decision – whether a customer is worth the financial risk of a loan – is done by a finance company, bank or credit union. In BHPH, the dealer’s money and collateral are on the line, not the bank’s, which means the dealer must be confident in the criteria he uses to determine risk.

“The goal of any underwriting should be to maximize sales, while at the same time not compromising your overall collectibility,” said Scott Carlson, managing partner of AutoZoom, a company specializing in scoring models for BHPH dealers. He noted that dealers new to BHPH often have problems determining which criteria to scrutinize in order to make good underwriting decisions. “The problem with that is … it’s a very expensive learning curve,” he said.

When talking to BHPH dealers about their underwriting decisions, stability and ability to pay are the two most frequently mentioned terms. However, those are general terms that encompass a range of factors. The number and importance of those factors vary from dealer to dealer. Ability to pay tops the list for many. “If they can’t afford the proposed car payment, then it doesn’t really matter how much stability, character or even down payment they have,” said Ryan Linnehan, co-owner of Linnehan’s Credit Now! Auto Company in Ellsworth, Maine.

The means of determining a customer’s ability to pay can differ. Melanie Jones, underwriter and collection manager at James Wood Motors in Decatur, Texas, looks primarily at the payment-to-income ratio. The car payment, she said, should be no more than 10 to 15 percent of their net income (not gross). “If you’ve got their payment too high, you set them up for failure right away,” she stated.

Alan Mosher, general manager of Instant Car Credit in Dixon, Ill., agreed. He will allow for a car payment that is up to 20 percent of a customer’s net income, but no higher.

Some dealers have their own internal scoring methods and will compile a budget on each customer to get an overall financial picture and determine what kind of car payment, if any, they can realistically handle. “We look closely at how much take-home pay is available in the household after paying basic living expenses, such as housing, utilities, groceries, etc.,” said Linnehan. “We review their debt-to-income as well as their disposable income levels and take into consideration other variables, such as number of people in the household and expected miles driven.”

Jim Hendrickson, an owner and manager at Autosmart Acceptance Corp. in Texarkana, Texas, takes a similar approach. For starters, he wants customers to have at least $1,000 to $1,200 net income per month; then, he begins looking at where that money’s going. “We’re looking at major expenses,” he stressed, adding that by looking at every single expense a customer has, “You could budget every one of these customers out of a car loan.”

That sentiment was echoed somewhat by Carlson. He did not recommend relying heavily on debt-to-income ratios, instead emphasizing the payment-to-income ratio. “What you really have to do is just make sure the deal makes sense. You’re not trying to put a guy that can afford a Ford Pinto in a Maserati or something,” he pointed out. “The payment has to make sense.”

In his experience, budgeting often causes dealers to be too conservative and miss out on deals, simply because they want the customer to have a certain amount left over for a car payment after figuring in all the little incidentals. “That is too restrictive because it is all subject to change,” he said. “You don’t know where all their income comes from; they’re not going to disclose everything.” He added that there’s no way to predict if customers have family to help them out, or if they’ll get another job to make ends meet or cut back on expenses to make the payment work.

While the customer’s ability to pay is one of the most important things to consider, it is not the only thing to consider. A customer’s stability, which encompasses both residential and job stability, is just as important to many dealers, although they differ in their opinions of what is acceptable. 

Jones looks for two to four years’ worth of stability. However, that may not necessarily mean two to four years living at one residence or working for the same employer. Different jobs within the same field and addresses within a few miles’ radius are acceptable to her. She also prefers to get a customer’s references at the beginning of the process in order to verify that the person has roots in the area.

Robert Rodriquez, sales manager at Fiesta Motors of Lubbock, Texas, places emphasis on the customer’s class of job in terms of whether it is skilled labor (like welding or masonry) or unskilled labor. He is fairly comfortable with a customer who has a recent job change if that person remains in the same field of employment. Instability in the job history of an unskilled worker, however, means “they’re more likely to default on the loan,” he said. He pulls bureaus on all of his customers, not necessarily to evaluate their credit score, but to see the length of their credit history and their time in the area.

Hendrickson prefers customers to have steady employment, which he defines as a year or more on the job. He requires a minimum of six months with the same employer. However, he is slightly more lenient on residential stability. He commented that being in the same residence for a while helps a customer’s chances for approval but, like Jones, he’s more concerned about whether that customer has been in the general area for some time and if they have roots there. Job-hoppers are a bigger concern. “They’re the ones that are apt to … move away with your collateral,” he said. The overall goal is to weed out customers who have little or no incentive to stick around.

Tina Faucette, co-owner of Harrison Motors in Apopka, Fla., claims the use of GPS on their vehicles has lessened the importance of residential stability. While she still requires documentation from the customer, having GPS as a backup makes her a little less concerned about residential stability. “At one point, if they couldn’t prove to me where they lived, I wouldn’t be able to finance them,” she said, “so now it’s not that much of an issue.”

Faucette pulls credit bureaus on all customers and watches for repeated inquiries from the same finance source. It tells her that someone who previously gave that person car financing has been looking for them, which means the customer could be higher-risk. She also watches for customers who carry so much debt that they would benefit from filing bankruptcy. Those customers, she cautioned, could purchase a car and then file bankruptcy a month later; the contract would never be paid.

Faucette considers a credit history with multiple repossessions a deal breaker. Not all dealers stay away from multiple repos, but most will exercise caution with such a customer. Jones, for example, will approach a deal carefully if a customer has a repo within the past two years. When the repo occurs within that time frame, she explained, she has to wonder if the customer’s situation has changed enough to warrant the risk. Rodriquez noted that most of his customers have repos on their records. The deal breaker for him is usually a customer who has multiple repos in the last three years.

Mosher stated that a prior repo is acceptable, as long as that prior repo was not with him. “They get one bite at the apple,” he quipped. “If there are repos on their credit bureau, more times than not, that’s going to be conventional financing and that’s why they’ve got to be at a buy here pay here lot anyway, so I don’t hold that against him,” he explained. “I have dozens of customers who can make a $60-a-week payment but could never budget for a $250-a-month payment because they’re not good money managers.” He won’t disqualify a customer for having multiple repos, but he does scrutinize the deal more closely. “Every situation is different. We try not to be too rigid in our policies that we can’t make an exception where one is warranted.”

It’s up to dealers to decide which underwriting factors to give the most weight to, but they will still need to consider the overall picture to make the most informed decision. Said Carlson, “You need to come up with a series of criteria or categories that have to do with residence stability, time in area…number of job changes, what types of employment, an individual’s verified monthly income, if they have previous car credits, number of times repoed in a given period of time, length of credit history, credit bureau score—these are the things we measure.”

Carlson and others cautioned against one of the bigger underwriting pitfalls for BHPH dealers: depending too much on down payment. According to Carlson, dealers who have a down-payment-driven business are essentially relying on that down payment to take the place of good underwriting and are not paying attention to the things they should.

Mosher agreed, stating that he believed the tendency in the BHPH business is to accept a little more risk with more money down. However, he cautioned, “Down has nothing to do with whether that’s going to be a good account or a bad account. Don’t let big down payments convince you to make a deal.” 

Linnehan added, “From reviewing the thousands of contracts on our books over the years, we really haven’t found a strong correlation that would tell us that a customer with a big down payment is more likely to pay the entire contract.” Income tax season can be particularly risky if a dealer does not exercise caution. Linnehan continued, “A lot of the static pool studies I have seen show that contracts written during tax season charge off at a faster rate than those written in other months. I think a big part of it is that the BHPH dealer is falling in love with the bigger down payments and ignoring the other signals that would alert them as to whether the applicant is qualified.”

“You have to remember that money has not been saved or earned,” Jones pointed out. “Next month they don’t have that money to fall back on and they’re living back on their paycheck.”

Rodriquez agreed. “Everybody looks good in January and February.” Rodriquez said even the bigger and more experienced BHPH dealers can end up with a few bad deals on the books because they overlook risk in favor of a big down payment: “Because they have $2,500 or $3,000 down, we get stupid and we put them in a car anyway … and nine months later we have a repossession on our hands.”

At one time, a dealer could often cover most or all of the cost they had in the car with the down payment and carry little or no risk in a deal. That is no longer the case. Instead of structuring a deal based solely on down payment and car cost, dealers must now be able to look at who the customer is and work the deal accordingly.

The BHPH industry has grown, car values have risen steadily over the years and competition for customers is greater than ever. Risk is inherent in the BHPH business, but a strong underwriting process can ensure success.