Description of Installment Loan Calendar Systems
Difference in Finance Charges
Prepaid Finance Charges
Buying Down the Interest Rate
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
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
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
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.
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
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
BuyRate: The "buy" rate is the rate used by the lender to
calculate the finance charge to be retained by the lender.
Lender's Retention: In calculating the lender's retention,
the interest amount is determined without adjusting the recalculated
payment to a whole cent.
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
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.