Before the days of the Internet, credit bureaus or even the telephone, bankers loaned money to consumers to purchase items that they otherwise could not afford. Banking was a professional art where the often intimidating loan officer would structure a loan around what was called the Three “C’s” of Finance – Character, Capability, and Collateral. Today, the Three C’s have evolved into the Five Credit Standards of Banking upon which all loans are structured and collectively help determine whether a lender says yes or no to an application for a loan. It is essential that anyone in the car business who is engaged in indirect consumer lending thoroughly know and understand each of these five standards.

The Five Credit Standards of Banking
1. Credit
2. Stability
3. Ability
4. Collateral
5. Structure

The first of these five standards, credit, is the most misused and misunderstood of all. Bankers, loan officers, F&I managers, and nearly everyone involved in the financing process of an automobile tend to focus on the credit score more than anything else. The information is so readily available that most dealerships inquire about a customers credit before ever meeting them face-to-face. In fact, many incorrectly pre-screen these customers early in the process and completely derail a profitable sale before it ever gets started by paying too much attention to the credit score.

The most common mistake when looking at a customers credit report is to assume that this score tells the story. The depth of the credit history, types of credit, highest credit extended and currency of payments over the past two years are much more significant when structuring a special finance deal. Whether or not the customer has ever had a vehicle repossessed or filed a bankruptcy, what type of bankruptcy was filed, and if a bankruptcy was discharged or dismissed, all have critical influence over the lending decision in spite of the score. The point of understanding credit is about understanding the entire credit file and knowing how each lender interprets the information. The credit score itself is just a small part of the equation. The credit report, however, tells the story. The wise words of a successful BHPH car dealer in Louisiana perhaps tell it best: “You can tell a whole lot about how a customer is going to pay based on how they paid people in the past. If there’s not a good reason for them not paying in the past, I won’t loan them money.”

Stability, the second of the five standards, paints another picture about the character of an applicant. A customers stability is based on their time on the job and their time of residence, or the length of time they have lived in the local area. Basically, if a person cannot keep a job for an extended period of time, there is usually something wrong with his or her character, which is another warning sign to a lender. Also, if they have moved frequently over the past few years, ask yourself why. Are they running from someone? The answer is often yes and the reason is because they are dodging bill collectors, past due child support, tax liens or anyone else trying to collect on past obligations. The factor of stability takes a close and formal look at an applicants character to determine the level of risk for a loan. It is difficult to collect from someone who is unemployed or that you cannot find.

Ability is perhaps the single most important of all the five standards. It is the customer’s ability to pay for their existing debt, the normal costs of living and the new debt for which they are applying. Most lenders look closely at the gross monthly income to determine a maximum allowable monthly payment and calculate a payment to income ratio (PTI). Most special finance lenders cap this amount at 18 percent to 20 percent of the verifiable gross monthly income. Additionally, they want to keep the debt to income (DTI) ratio below 50 percent. For example, if you add up all the minimum payments for which an applicant is obligated monthly and add the new payment to the mix, the total cannot exceed 50 percent of the gross monthly income. Ability answers the question, “Can the customer afford this new car payment with their existing debt?”

Collateral is the vehicle being sold to the customer and the asset for which the lender is loaning money. Each vehicle has a book value, which to a banker is typically the Trade In value as listed in the current NADA evaluation guide book. This value is often very different than the “current market value” or actual cash value (ACV) of the vehicle. The book value, the age, mileage and stated options all factor to determine the amount of money a lender will loan on a specific vehicle and for how long of a term. Also, there are several vehicles, regardless of condition, that these lenders view as ineligible or “high risk.” Make sure you review the guidelines on makes, models, age, mileage requirements, and the associated loan terms for each lender with whom you do business. You can have an entire lot full of excellent inventory that customers want, but that’s no good to you if the banks will not loan money to customers to buy them at a term with an affordable payment.

Structure is the most complex of all the five standards. Deal structure determines profit. It dictates loan risk and will make or break the deal. The cardinal law of deal structure is affordability. Can the customer afford the payment? Can the bank afford the risk? Can the dealer afford the profit margin?

The risk meter for the bank is LTV (Loan to Value), how much money the bank is lending in relationship to the book value of the vehicle. A high LTV is a high risk for the bank; loan approvals are inversely proportional to LTV. As you lower the LTV, you are actually increasing the likelihood of an approval by decreasing the risk of the loan. It is ironic that customers who are a higher credit risk have a better chance getting financed on a newer vehicle with a higher book value than on older ones with less value, as long as LTV, PTI and DTI are in line.

DTI, PTI and LTV determine if the customer can actually afford the vehicle and how much money the lender is comfortable lending against it. This is why proof of income is so important for special finance deals. Together, these three ratios determine the amount of risk for the bank and whether or not your customer gets an approval. Every lender will differ on the thresholds for each ratio and adjust interest rates accordingly for the loans they approve. It is how banks compete.

Most lenders screen deals for approvals using an automated system and an internal scoring model to save both time and money. These automated systems will quickly decline deals that are structured incorrectly, limiting the options available to the credit manager (loan buyer at the bank) or even worse, preventing a dialogue between the buyer and your finance manager. Instead, I recommend that you get the approval first then negotiate with the bank afterwards. Finance managers who don’t understand the Five Standards of Banking will have a difficult time getting approvals and leave a fortune in profits on the table with deals that are structured incorrectly or on vehicles the customer cannot afford. This concept is one of the key elements for success in special finance and perhaps the most important.

To be effective, finance managers must speak the language of these Five Standards and thoroughly understand the programs and underwriting guidelines for each lender with whom they do business. They must structure and submit deals accordingly and consistently. Lenders are your most important business partners, and the goal is for your finance manager to discuss each and every deal with the credit manager at the bank. This business is done by people and through relationships and a professional dialogue between your dealership and the bank is good for business. Treat your relationships with banks as partnerships in profitability.

Mr. Tom Herald is a Professional Consultant and National Trainer and with Benjamin Herald Associates. He has over 20 years of experience in the automobile business and 10 years as a dealer principal. He is a former Air Force Commander with extensive training as a leader and instructor. He is one of the top experts on Special Finance and can be reached at [email protected] or by phone 859.816.7990 

Special Finance Insider Vol. 1, Issue 2