Description of Installment Loan Calendar Systems

 

Difference in Finance Charges
Present Value
Pro-Rate Reserve
Prepaid Finance Charges
Buying Down the Interest Rate
Credit Insurance
Sample Dealer Reserve Calculations

Dealer Reserve refers to an amount given as a commission or payment to a dealer or other indirect loan source as compensation for generating the loan. The commission or "dealer reserve" can be computed by a number of different methods. Some of these methods and related items are described here.

 

Difference in Finance Charges

This method is the most common (it is used by virtually all captive-finance companies) and is the easiest to understand. The loan is recalculated at the buy interest rate, and the resulting interest charge is retained by the lender. The dealer reserve is the difference between this interest charge and the interest charge on the contract.

The lender's yield on the loan is slightly below the entered buy rate because the lender advances the dealer reserve amount at the start of the loan and yet must wait for the stream of payments to be repaid. Thus the dealer reserve amount becomes a no-interest loan that reduces the lender's overall yield on the loan slightly. The present value method takes this timing into account and computes a slightly smaller dealer-reserve amount that maintains the lender's yield.

There are a couple of options that are commonly used with the difference in charges method:

  • Frequently, only a portion of the calculated dealer reserve is paid to the dealer. This is done to compensate the lender for the fact that some loans will be paid off early, depriving the lender of the full amount of interest. Rather than charge the dealer back at some later time for loans paid off early, only a percentage of the calculated dealer reserve is actually paid to the dealer (typically 65%-80%).

  • Many lenders establish a minimum dealer reserve, so even if the buy rate is the same as the loan interest rate, the dealer will receive a commission. If both a percentage paid and minimum amount are used, the minimum is typically applied after the percentage paid is applied.

For interest-rate buy downs, the reverse error occurs and the buy-down amount is too high when the difference-in-charges method is used. Again, the present value method will produce the accurate amount.

 

Present Value Reserve

This method discounts the stream of monthly payments at the simple buy interest rate (using the actuarial method of compounding interest) to find the present value of the stream of payments. The note amount is subtracted from the calculated present value amount to find the dealer reserve.

This method discounts the stream of payments at the simple buy rate (using the actuarial method of compounding interest) to find the present value. The note amount is subtracted from this present value to find the dealer reserve.

The lender's retention is the difference between the contract finance charge and dealer reserve. This method provides the lender with a yield equal to the simple buy rate if the dealer reserve is paid on the loan date (if the dealer reserve is held back, the lender's yield will improve).

This method can also be used to allow the dealer to "buy down" the interest rate, i.e., the dealer can advertise a lower interest rate than the lender is willing to accept. In this case, the reserve amount is actually negative, and represents the additional amount the dealer must give to the lender in order for the lender to realize the buy rate. This is the most accurate method of computing an interest rate buy down.

 

Pro-Rate Reserve

This method is designed to compute the total reserve the dealer will receive when the reserve is paid over the life of the loan. Each month the dealer receives a portion of the interest collected by the lender.

If the loan is paid off early, the dealer reserve payments stop.

The lender's total retention (assuming the loan runs to maturity) is computed by prorating the simple buy rate to the loan interest rate. The dealer reserve is the difference between the contract finance charge and the lender's retention.

This method came into being when simple-interest loans were new, and it was designed to make the dealer share in the stream of interest income from the loan rather than getting the entire dealer reserve up front. The method has not been very popular and is not used very often.

 

Prepaid Finance Charge

Some loans have a prepaid finance charge which constitutes part of the Finance Charge. In this case, the loan interest rate will be lower than the contract A.P.R.

When there is a prepaid finance charge, the charge is usually passed to the lender in its entirety.

 

Buying Down the Interest Rate

A common method of promoting automobile and other product sales is to offer the buyers a very low, even 0%, interest rate. The rate is usually well below the true cost of money. To induce a lender to accept the loans, the dealer "buys down" the interest rate by making an additional payment to the lender.

To calculate this buy-down amount, check the loan and compute the dealer reserve using the Present Value method. Enter the lender's required rate as the Buy Rate. The buy down amount will be calculated, which is the amount the dealer must advance to the lender.

In practice, the lender simply reduces the advance to the dealer by the buy-down amount, e.g., if the amount financed on the contract is $14,300 and the buy-down amount is $350, the lender would advance $13,950 to the dealer.

 

Credit Insurance

Dealer reserve calculations can be made accurately on any loan with single-premium credit insurance. On this type of loan, the entire credit insurance premium for life, disability, and involuntary unemployment insurance is added to and becomes part of the amount financed.

Provided the purchase of credit insurance is optional and not a condition of providing credit, the premiums are not considered part of the finance charge.

These dealer reserve methods will not work properly if the credit insurance is required and therefore is part of the finance charge, nor will they work properly for loans with monthly-outstanding-balance credit insurance.


End Note


BuyRate: The "buy" rate is the rate used by the lender to calculate the finance charge to be retained by the lender.


End Note


Lender's Retention: In calculating the lender's retention, the interest amount is determined without adjusting the recalculated payment to a whole cent.


End Note


Buy-Down Calculation: The buy-down calculation is much like pricing a bond. The loan as cast by the dealer represents a stream of payments to be made to the lender. This stream of payments is discounted at the lender's required rate (buy rate) to find the present value. This present value (which is less than the note amount because of the discounted loan interest rate) is subtracted from the note amount to find the additional amount the dealer must advance to the lender in order for the lender to realize the required rate.

As an example, consider a $15,000, 36-month loan at 3.9%. Loan is made on 5/1/99 with the first payment due 6/1/99 (31 days later using an Actual calendar to the first payment). The monthly payment is $442.22. The lender will accept the loan at 8%, and using a rate of 8%, the present-value buy-down amount is calculated at $889.75. Thus, the stream of 36 payments discounted at 8% has a present value of $14,110.25 to the lender, some $889.75 less than the amount financed of $15,000.