Tuesday, October 9, 2007
A Look at How Some Industries Generate Lots of Excess Revenue Through Sub-Prime Consumer Loan Programs
Many businesses selling goods or services that retail for $300 or more experience the same problem; trying to get financing for customers with less than perfect credit. It is heartbreaking when someone is eager to purchase your product, only to find out they have no way of paying for it. When that customer walks out the door, potential revenue follows them.
Finding solutions to this problem can be difficult. Sub prime consumer loan programs aren't easy to find. Most banks typically steer clear of sub prime unsecured lending. Many businesses often resort to financing these customers in house which is time consuming and expensive to manage and doesn't deliver immediate cash like typical consumer finance programs or credit cards do. So what other options do businesses have?
Installment contract funding is an answer that many industries have successfully turned to for years. In these programs, businesses sell their newly generated receivables to finance companies for immediate cash on a weekly, bi weekly, or monthly basis depending on volume. The program works much like any A credit financing program would. The customer fills out a credit application. If they are denied by the businesses first look option, they are then sent to the second look option for approval. The second look program is designed to accept a good number of those consumers who the A credit lender deemed "unworthy". The second look option will underwrite the loan and if it passes predetermined criteria, the lender will purchase the loan from the business, giving the business immediate cash for the receivable and then collecting the debt from the consumer just like the A credit lender does.
Because the second look option accepts a lesser credit class of consumers, it can not fund the business 100% of the principle balance like the A Lender. The default rate on the portfolio will be much higher for the second look option as well as the overhead. It is much more expensive to collect from sub prime debtors as it is from good credit debtors. To offset the higher default rate and overhead, lenders will charge the business a discount fee. It works much like the fee credit card companies charge and it is usually determined by the expected default rate on the portfolio. The more approvals you want (meaning the deeper the finance company will approve credit) the more it will cost because the default rates will raise as you move lower into FICO scores. The discount fee also enables the lender to charge a more competitive interest rate so that your customers will be happy. Discounts can vary greatly from as low as 5% to as high as 50% or more.
A typical loan purchase might look like this:
- Product/Service sells for $2,000
- Business receives a down payment of $500
- Finances $1500 to consumer
- Second Look option approves loan for purchase at a 15% discount ($1275 is funded)
- Lender funds business $1275 - Customer put $500 down - giving the business $1775 in cash for the $2000 product/ service.
From this example you can see that the business was able to make the sale and generated $1775 in cash from the transaction as opposed to the customer walking out the door and the business receiving $0.
Because discounts make these programs work, they are best used in industries that have high product margins so that they can comfortably absorb the discount and still make a sizable profit. Generally you need a markup of 40% or more from what the product or service actually costs you to deliver. Service based industries are perfect matches for these programs. Here is a list of industries where this type of financing and receivables management works well:
- Trade / Vocational Schools
- Travel / Vacation Clubs
- Funeral Services
- Computer Sales
- Consulting Services
- Fitness / Health Programs
- Medical Procedures
- Cosmetic Surgery
- Hair Transplantation
- Infomercial Sales
- College Prep