Dealer Reserve: Making Cents of the Controversy

Unless you've been hiding under a rock the past few months, you've probably seen at least one news story in the press trumpeting abuses in the dealership finance office. Countless newspapers have published the token exposé on dealer-arranged financing, quoting car buyers who thought they were getting a competitive loan interest rate only to later discover that they were victims of gouging.

The negative publicity has had significant ramifications. Captive finance companies and banks have continued to set caps on markups in response to lawsuits and public scrutiny. Consumer groups and attorneys general are pushing for legislation that would shrink and regulate so-called dealer kickbacks. Plaintiffs' attorneys that have targeted auto finance companies for alleged abuses are now suing megadealers (who also happen to have deep pockets). And many of them seek class-action certification.

F&I managers and dealer advocates are outraged, arguing that these critics are blowing the problem out of proportion. "Of course, in every industry, you're going to find people who are abusing the system," says Ron Martin, trainer and president of The Vision of F&I. "But it certainly isn't as widespread a problem as some would like you to think. For some time now, lenders have placed limits on rate spreads. Market conditions have also required dealers to keep rates low."

Nevertheless, what does all this hoopla mean for dealerships? When the smoke clears from the barrage of assaults on dealer reserve, in what shape will you find your finance office? Weaning your store off reserve income today will help your business to thrive, regardless of what the rules of F&I are when the dust settles.

Rate Faces Multiple Pressures

Finance managers are baffled by the overreaching measures to regulate reserve profit. "If profit disclosure is going to be the standard, then it should be that way for all products in all industries," says Michael Krail, F&I manager at Land Rover Princeton in Princeton, N.J.

"While we're at it, why don’t we require that every sales transaction for every item sold in the United States come with a full disclosure? When I buy a pack of gum, a newspaper, furniture, toys, games, food or anything else, I deserve a disclosure," says Krail. "It gets to the point of ridiculousness. The disclosure requirement needs to apply to all or none."

But legislation in certain states is in fact singling out the auto industry to require profit disclosure to customers. In California, the so-called car buyer's bill of rights, which requires that charges are consistent and fully disclosed, passed in the Assembly and moved to the Senate for a vote. Related measures have been pushed in New York, Illinois and Tennessee but haven't made as much headway.

Whether the laws will be passed remains to be seen. Meanwhile, dealers face tightening restraints on reserve from auto lenders. Lawsuits alleging unfair and discriminatory financing prompted many major manufacturers' finance arms to cap the markups they allow dealers. Nissan Motor Acceptance Corp. became the first captive finance company to settle a class-action suit last year. The company -- without admitting guilt -- established a 3 percent cap on markups. Ford Motor Credit Co. put a 3 percent limit in place a few years ago.

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In February, General Motors Acceptance Corp. raised the bar by setting a 2.5 percent cap on loans up to five years and 2 percent on extended-term loans. J.P. Morgan Chase followed the precedent with a 2.5 percent cap effective June 1, 2004. According to industry observers, GMAC's move may put some downward pressure on rate caps.

But Chrysler Financial Services says it isn't making any sudden policy changes in response to the recent spotlight on dealer financing. It is, however, adjusting its contracts to include the disclosures about financing recommended by the National Automobile Dealers Association and American Financial Services Association. The disclosures inform consumers that they can negotiate the annual percentage rate and that the dealer may retain a portion of the finance charge.

Also, Chrysler Financial executives recently visited dealers and finance managers in 27 cities to discuss these issues and get their feedback. "We want to talk with dealers and come up with solutions that are viable for everybody -- Chrysler Financial, the manufacturer and our dealers," says spokesperson Amber Paauwe.

The trend toward rate caps shouldn't have a major impact on dealerships that have had to adjust to zero-percent financing and flat fees in recent years.

"Here in Wake Forest (N.C.), reduced point spreads have been a way of life since about October 2001," explains Johnny Dudley, finance director at Chris Leith Automotive. That was the time when manufacturers began pushing incentives and zero-percent rates.

"We had to shift our thinking from an 'old school' method of selling rate and a limited number of products to living without reserve profit and offering customers a variety of quality products that would enhance their ownership experience," says Dudley.

The change of approach has proved profitable for Chris Leith Automotive. Its percentages of product to total sales have improved while maintaining PRU dollars and reducing chargebacks. "I think we're well positioned for dwindling reserve profits," says Dudley.

If Reserve Were Lost

What if reserve were eliminated entirely? "Giving up reserve would hurt a lot," says Terry Norman, F&I manager at Hunter Chevrolet in Hendersonville, N.C.

Norman says some of his lenders currently don't cap rates. He estimates that half of his store's income is reserve and to lose it would require an overhaul in the store's F&I practice. "I'd be forced to really hammer warranties, GAP, etch, tire guard, security, etc.," he says.

Krail believes a loss of reserve would ultimately reduce the F&I function to an administrative task. "It would completely change the F&I process," he says.

"Reserve makes up a major portion of our pay and taking it away would cause the pay rate to be lower, which would lower the quality of the people doing the job," says Krail. "F&I would become a clerical position. It would put the responsibility of aftersale in the salespeople's hands, which would lead to much lower profits."

But Martin says reserve won’t be eliminated.

"There has never been a greater need for a centralized loan office, which the dealership provides," says Martin. "With bank mergers and the ease of obtaining financing online, the F&I office provides an excellent means to close installment loans that were previously handled by personal loan officers. The dealer will have to be compensated for that." He does, however, concede that reserve will be reduced.

Stacy Adamuska, business manager at Tri-State Toyota Dodge in Dudley, Mass., says the time will soon come when dealers don't get rates at all -- only flat fees. And her dealership has taken steps to adapt to the change.

"We have already started selling new product, from biweekly payments to back-up sensors," says Adamuska.

Back to the Products

Adding new, tangible aftermarket products to your F&I lineup is one way of compensating for shrinking reserve margins. Dealerships can also refocus on selling the value of existing, tried-and-true products.

"The aggressive F&I manager looks at this problem as an opportunity," says Martin. "Lower rates allow the dealership to retain a higher percentage of financing. It also leaves customers with more income to purchase products that benefit them."

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Martin contrasts the aggressive F&I manager with the deceptive one. "Deceptive F&I managers don't believe in what they do, so they resort to trickery and manipulation in order to produce income," he explains. "Aggressive F&I managers believe in products they offer or they don't sell them, understand the products completely, put the customer first and expect to be successful. The lion's share of their income comes from products that provide the customer benefits."

Dudley agrees that the controversy over F&I practices should be taken as a wake-up call to inspire greater professionalism. "Our world is changing but the sky is not falling," says Dudley. "With product mixes, proper training and the right lending relationships, we can actually take it to another level.

"Think about it, we're being held to a higher standard. Why not take a proactive approach in becoming leaders in our profession. We must constantly continue to be responsible with our policies, practices and training. If we take such an approach, the regulation of reserve is just a change -- not a detriment," says Dudley.

Self-regulation of reserve policy is another measure dealers can take to be proactive. Such efforts will help car buyers feel more confident that they'll receive equitable financing through the dealership. Krail says the family of dealerships he works for set its rate cap at 2.5 percent.

Martin suggests that implementing flat fees can ease consumer skepticism.

"Trying to explain to customers the value you have to the transaction will be more trouble than it's worth," says Martin. "Create a flat fee based on the term and amount financed and let the lenders compete on that level. The market has a way of fixing itself. Then we can put this behind us."

However, if you do continue to charge rate, consult your attorney or state association about the legal requirements surrounding finance reserve. Then develop a sound explanation to give to customers who question the practice.

Martin offers a sample explanation: "As allowed by the law, the dealership will retain two points on your loan as compensation for arranging your financing. You have the option to obtain your own financing if you choose. We feel confident that you will find the rate we are charging to be competitive. The rate is fixed throughout the term of the contract and is a simple interest amortization. We can provide you the convenience of not having to shop around for a loan and finishing the transaction now."

Michael Carrington, senior business manager at North Trail RV Center in Fort Myers, Fla., is similarly prepared to answer skeptical car buyers, particularly as they are increasingly educated and informed.

"The facts are simple," Carrington explains. "Dealer (indirect) lending arrangements provide a service for which there is clearly a need. As such, it is clearly a compensable business transaction. Most dealership-arranged loans are as, if not more, competitive than outside financing. The vast majority of dealers and finance managers alike are chargeback-sensitive and conduct their practices accordingly. Those that aren't doing so have very short-term goals."