Buying Paper from a Used Car Dealer
Dealer reserves in indirect lending serve to protect a bank against loan losses and prepayments. Suppose that a bank enters into an agreement with a used car dealer to buy dealer paper at a 5.5 percent add-on rate and retain 25 percent of the interest differential relative to the rate the dealer charges the car buyer. Under the agreement, the bank charges losses and prepayments against the reserve, transferring any excess to the dealer periodically. Interest rebates on prepayments are computed according to the rule of 78s.
Consider the case where the dealer charges a customer a 7.5 percent add-on rate for the purchase of a $15,000 automobile to be financed over 36 months. Calculate the effective APR, the total interest expense to the customer, the bank’s share, and the interest differential allocated to the dealer reserve. Suppose that the customer prepays the entire loan after 13 months. Determine how much interest the bank must rebate to the car buyer and any charge to the dealer reserve.
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