Rewards of the Sub-Prime Market

Sub-prime sales have a come along way in recent years. In the past, most franchised dealers couldn’t see the potential for profits from sub-prime business.  They dismissed it outright as “too risky.” They thought credit-challenged, lower income customers were someone else’s problem, rather than an opportunity for increased business. They virtually shut out huge numbers of lower income customers, simply because they didn’t meet the income requirements for prime-rate financing. Meanwhile, the “buy here/pay here” lots were overrun with new customers. Despite the volume of customers flooding the “buy here/pay here” lots, most franchised dealers still couldn’t see the benefit of gambling on these non-prime deals. 

All that changed when the statistics regarding sub-prime car loans became none.  The delinquency rates on these “risky” loans were far lower than expected, even when compared to delinquency rates on prime loans. According to Anne Kim, director of the Progressive Policy Institute’s Work, Family, and Community Project, at Household Finance Corporation, “one of the nation’s largest sub-prime financiers… delinquency ratios in 2001 varied between 1.77 and 2.89 percent, comparable to the 2.4 percent delinquency rates at the prime-rate General Motors Acceptance Corp.” Tremendous growth was evident as well, as Household “serviced nearly $6.4 billion in auto loan receivables in fiscal year 2001, more than double the amount serviced only two years before.”

Suddenly, the risky gamble seemed a safe bet. More banks and financial institutions decided to get in on the action of offering credit to customers with marginal ratings. They realized that many individuals with a less than stellar payment history were not willfully negligent, but had simply experienced a temporary financial hardship—and many more were perfectly able to meet their car loan responsibilities, provided they were given an interest that wouldn’t jeopardize their ability to pay bills. Many of these customers had formerly been quite conscientious about paying their bills, but had delinquent credit records due to circumstances beyond their control, such as a sudden job loss or an unforeseen medical expense.   Still others had never defaulted on a payment, but lacked a sufficient credit history to prove it, such as recent immigrants, former welfare recipients, or young customers.  

A study entitled, What Drives Default and Prepayment on Sub-prime Auto Loans? by Erik Heitfield  and Tarun Sabarwal revealed that “at the end of 2001, principal outstanding on loans in pools securitized by companies specializing in sub-prime automobile lending stood at $30 billion.” Heitfield and Sabarwal also found that “…interest rates may directly affect borrower behavior. Borrowers faced with the high monthly payments associated with high interest rate loans may have more difficulty making regular loan payments.” Literally millions of customers wanted to re-establish their credit and enjoy a new car while doing it. The key was offering vehicle loans at slightly lower rates than those offered by the scam dealers. 

Sub-prime business took on a new importance as franchised dealers embraced this new market. With new car sales dipping and little income from the front end, they finally saw the sub-prime business as an opportunity to recoup lost profits and sales. At the same time, once-shunned customers accepted substantially higher interest rates, believing the rewards of buying a better car from a more reputable dealer would be worth the extra cost.

Energized by this new income possibility, many dealerships opened separate departments to house their sub-prime business.  This move was seen as a way to decrease any potentially negative impact sub-prime business might have on their conventional sales. They hired finance managers dedicated to working sub-prime business and then signed up with various banks to finance their customers. Some were savvy enough to realize that their used-car inventory needed to be adjusted to accommodate the advances on sub-prime credit calls. They expected to sell more cars and bring in higher profits. And they have.

But for many dealers, getting into the sub-prime business hasn’t been so easy. These dealers failed to realize that “business as usual” wouldn’t work in a successful sub-prime department.  An entire culture change in the department’s methods of operation was required. Twenty year-old sales processes had to evolve if the rewards from sub-prime customer financing were to be reaped.

Unfortunately, some dealers were too timid to make the changes.  The sub-prime department’s business was kept secret and removed from the heartbeat of the dealership.  Without support from the entire dealership, these sub-prime departments floundered. 

Different Game, Different Rules

Any dealership can develop a successful, profitable sub-prime department; they first must to accept that working with sub-prime customers is not the same as working with prime-rate customers.  A new approach, complete with a new vocabulary, must be put into place. The whole dealership must be fluent in this new language, if the venture into sub-prime financing is to be successful. Why? Customers must be cordially and correctly greeted on the lot and every sales person must be trained on the specific word tracks that will elicit necessary information. Specific financial details (i.e., monthly payments, sale prices, discounts, and down payments) are never discussed at this time.  Instead, this is the time to gauge the customer’s ability to qualify for a “buy.” An effective sales person will know how to build rapport, while moving through the qualifying questions. The only way to prepare the staff is through rigorous, proper training.  Otherwise, the transaction may be “lost in translation.”

Qualifying Routine

The initial customer interview lays the foundation for a successful sale.  Every point must be addressed in order to obtain a complete overview of the customer’s financial state.  At the same time, the customer must feel they are engaged in a conversation, not undergoing an interrogation.

• Hi! My name is John Doe. Welcome to ABC Motors. Are you here to see anyone in particular, or because of a promotion we have advertised? Or, are you here to check out a new or used car or truck?
• Are you currently financing a vehicle? How many months have you been making payments?
• What bank is financing your loan?
• Have you lived in this area a long time?
• Are you a homeowner or do you rent?
• What do you do for a living?
• Where do you work? Have you been there long?
• What do you like about the vehicle you’re trading? Anything you don’t like about it?
• What would like your new vehicle to include that you don’t have now?
• Are all the decision makers in your family here today? 

Incomplete initial information can undermine the sale later in the transaction. The qualifying questions should help the sales person determine if the customer can buy: certain “red flags,” such as a slow-pay credit rating or job instability, may be inferred from the conversation. It is important to note once a salesperson begins to negotiate the sale on the lot, it is very difficult to turn the sale around, if management determines the customer is sub-prime.

Consistency is Key

Sales managers must be trained in sub-prime financing. The process cannot be left to solely to finance managers. Why? Because untrained sales managers can inadvertently destroy profits and sales! It is essential they know how to work and structure sales prior to negotiating payments and terms with customers. Lacking this important knowledge, they run the risk of undermining the sale completely.

For example, they cannot charge customers for the lender’s acquisition fee. Dealers must absorb this cost themselves, because it is illegal to add the acquisition fee to the customer’s cost, once the transaction has been negotiated. Many untrained sales managers will work the deal without pulling credit, and proceed blindly into the negotiation of terms and payments. Once customers agree to the sale, sales managers may pull credit, but this is usually too late; the customer won’t budge from the payment or terms agreed upon. Although the bank may be willing to take the deal, they won’t accept it under the unrealistic terms negotiated. This puts the sales managers in an incredibly awkward situation: either they must reduce the profit even further in order to make the sale, or risk losing the sale altogether.

If sales managers assume that all sub-prime customers are gold and neglect to review their pay-back history, they can sabotage the deal. The customer must always be provided with a consistent sale price before discounts.  If the salesperson quotes a sales price which assumes the customer will qualify under the terms of prime financing, they run the risk of being blindsided by a poor credit history. This will leave them scrambling to recover the deal; in most cases, customers will be so upset at the sudden change in terms, they will walk away.  The best policy is quoting the standard sub-prime minimum (twenty percent down, two payment options figured on an average rate factor). Then, when customers want to discuss lower payments or different terms, it’s a perfect opportunity for the manager to pull credit. The manager will be in complete control of the transaction.  Once the credit has been pulled, the sales manager should immediately intercede if the customer is pursuing a car which is out of their financial reach.

Complicating matters further is the fact that many sales managers aren’t paid on sub-prime credit transactions.  This often drives them to work their deals until all the profit is exhausted, even past the point that the customer should have been turned over to the sub-prime department. By this time, the customers are worn out and confused, and the excitement over the possibility of buying a decent car is long over. Now, the sub-prime manager has nothing left to offer them.  So, even if a deal is made at all, there is generally minimal profit to be made. However, a properly trained sales manager will not let a pay plan destroy efforts in the sub-prime department.

In truth, any dealership that expands into sub-prime sales can increase profits and sales . . . if a consistent sales process on the floor is implemented wisely. Sales personnel must all be included in the training and know-how equation. They must be adept at managing sub-prime customers, and know how to elicit the necessary information what questions are important from the meet and greet stage to the first presentation of numbers. They must know the importance of pulling credit history, prior to negotiating terms and rates. If they start the deal with a consistent pricing strategy and offer payments that utilize an average interest rate factor, the dealership will realize more car sales and more profit.

Does this gamble really pay off?  Sub-prime borrowers, many of whom have dealt with dishonest dealers with lower quality cars and exorbitant interest rates, are often all too eager to prove themselves “worthy” of a dealer’s fair, good-faith loan. . . even at sub-prime rates.  The opportunity to do business with a reputable dealer is often well worth the cost. For the dealer, the risk of a sub-prime customer defaulting on a loan is outweighed by the potential profit.