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MAKE YOUR INSTALLMENT CONTRACTS SIMPLE !
BY KEN NE TH B. SHI L SON , CPA
As I work with Buy Here, Pay Here dealers throughout the nation, I am surprised that
many of them still use the pre-computed interest method in their automotive installment
contracts with customers. In the past, pre-computed interest contracts were prevalent because
dealer management software systems had not developed the sophistication needed to make the
more involved simple interest calculations.
Let me explain further. Pre-computed contracts (usually using the rule of 78’s method),
calculate finance charges (interest) over the term of a contract assuming that the customer will
make all payments in accordance with a predetermined amortization schedule. If the customer
pays late, finance charges are not re-determined. On the other hand, simple interest calculations
consider the time value of money. That is, the amount of interest due is determined by the date
the customer actually makes a payment. When a customer pays late, more interest is accrued on
the customer’s unpaid balance. Over the life of the contract, a customer will pay more interest
using the simple interest method if all payments are not made in accordance with the scheduled
amortization.
If dealers will actually receive more interest, why doesn’t everyone immediately switch
to simple interest? Not so fast! Here are the major reasons I’m normally given…
1) Simple interest requires different installment contract disclosures and some dealers
don’t want to incur the expense to change.
2) It is not legal to change from pre-computed contracts to simple without re-contracting
the customer. Therefore, dealers who change to simple interest calculations must do
so only on new customers. As a result, they will have a portfolio of customers using
two different interest calculation methods. Some dealers consider this to be too
confusing.
3) Although simple interest will yield more interest over the life of the contract, precomputed,
rule of 78 contracts, recognizes more income during the early portion of an
installment contract. Therefore a change to simple interest may initially result in
lower interest income recognition before the longer term benefits are fully realized.
4) Dealers who utilize pre-computed contracts frequently charge late fees to compensate
when payments are received late. They believe that such fees largely offset the
economic benefit of using simple interest.
If all of this sounds confusing, I believe the answer is “simple”!
1) Most Buy Here, Pay Here customers don’t pay in accordance with an agreed upon
amortization schedule. Delinquency statistics for the industry reveal that at least 10%
of all customers pay late. During seasonal periods, this percentage is often much
higher (30% or greater). Therefore, simple interest would yield considerably more
interest in those circumstances.
2) The administrative drawbacks of changing are minimized when compared to the
additional cash flow and revenue a dealer will realize over the life of their portfolio.
3) Late charges on pre-computed contracts are considered to be financial “add-ons.”
They are often negotiated away by the dealer and forgiven when the customer finally
makes the payment. In my experience, these late charges never equal the additional
interest which can be earned and collected using simple interest.
4) From a collection perspective, the customer is more motivated to remit payments
more quickly to avoid additional interest accrual.
5) From an income tax perspective, simple interest produces a more favorable tax
answer.
In summary, I have advised many of my dealer clients to convert during the last few
years and those who did have all benefited from that decision. One final point, pre-computed
interest calculations are not permitted in all states so dealers are advised to become familiar with
the particular compliance requirements in their own state. It is recommended that dealers who
are still using pre-computed contracts consider the simple and more economically beneficial
alternative. Good luck!
Kenneth B. Shilson, CPA, is a Principal in Shilson, Goldberg, Cheung & Associates, LLP, and is President of
Subprime Analytics, which performs electronic portfolio analysis. Mr. Shilson is also the founder of the National
Alliance of Buy Here Pay Here Dealers (NABD) which will host a BHPH Collection Academy near Atlanta,
Georgia, at the Manheim DRIVE Center, January 9 – 11, 2007. Collection and underwriting practices will be
discussed in detail at the Collection Academy. For further information, visit the NABD website at
www.bhphinfo.com or call 713-290-8171.
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