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In response to what it sees as a troubling trend of auto-lending discrimination at banks, the Consumer Financial Protection Bureau is proposing to oversee the business practices of nonbank consumer auto lenders – including automakers’ financing units — in the same manner that it does the nation’s banks.

Reactions have been swift and searing.

The National Automobile Dealers Association publicized a plea for the bureau to accept the industry’s revised approach to preventing predatory lending practices in place of the bureau’s proposed course of action.

Congressional supporters have also weighed in with their strong views, some because their interests are aligned with the auto and finance industries. Others, I suppose, have joined the argument because this new conflict serves as a proxy for the ongoing debate about the CFPB itself, which they’ve opposed from the get-go.

The Business of Auto Financing

At roughly $900 billion, auto financing is the third largest form of consumer debt in the U.S. Without it, vehicle sales would grind to a halt because at just under $30,000 per unit, the average price of a new car is beyond the ability of most consumers to fund with cash-on-hand.

Buying on time has become an economic way of life for budget-conscious households. It’s been a godsend for sellers, too, not least because instead of having to defend against an objection to price, marketers of big-ticket items are able to sidestep the problem by pitching the comparative affordability of a monthly payment plan. But even that’s not their only reason for offering credit as an option.

Sellers of durable goods (items that have a long life-cycle and are bought infrequently, like household appliances or cars) often manage three areas of profitability for every sale they make: from the product itself, the service it’s likely to require over time and via the financing their customers typically require. At issue, however, is the interplay between these three profit margins—in particular, the extent to which a seemingly cut-rate car price is being subsidized by an unfairly priced financing arrangement—that is attracting the CFPB’s scrutiny. Here’s how that can happen.

Suppose a car dealer sets its target at a 10% profit margin for every sale it makes. Also suppose that it’s only able to squeeze out $1,500 worth of profit from the $25,000 sale it’s about to close. Since the profit target for that sale is $2,500, the $1,000 shortfall would have to be made up some other way: through the dealership’s service department or by a financing deal.

After-market service is a crapshoot, though. Who’s to say that the buyer will follow the recommended maintenance schedule, let alone have that work done at the dealer’s shop? Financing is, by contrast, a much surer bet given that more than 80% of all auto sales are made possible with OPM (other people’s money). The key, however, is to find a way to inflate the financing deal by an additional $1,000.

Fortunately, the banks have been quite accommodating in this regard.

The financial institutions that fund these deals typically quote “buy rates” or “base rates” to their car dealer and nonbank cohorts, which they permit to be marked up as they see fit.

So continuing with our $25,000-purchase example, suppose the customer consents to a $5,000 down payment—which would be typical for a loan of this type—and requires a five-year repayment term for the $20,000 balance. Let’s also suppose that the bank has set a 5% buy rate for the deal.

Since the dealership wants to earn an additional $1,000 from the sale, and since that sum represents 5% of the value of the prospective loan, the dealer would then divide that 5% by the so-called half-life of the financing term—2.5 years, in this instance—and add the resultant 2% to the base rate. Consequently, the customer would be charged 7% for his loan rather than the 5% rate the bank has approved.

Incidentally, the longer the term, the lower the interest rate mark-up: If the aforementioned example were for a three-year loan instead of five, the mark-up works out to be 3.33% instead of 2%. Also note that all this math works in reverse when car dealer and manufacturers want to kick-start sales with offers of seemingly below-market-rate financing.

How Consumers Can Comparison-Shop

Clearly, the temptation exists to make even more money by way of this pecuniary prestidigitation—and that goes to the heart of the CFPB’s concern, particularly since its investigations have shown that those who can least afford the cost of borrowing are charged the most. But though the bureau has successfully enforced regulatory compliance and extracted tens of millions of dollars’ worth of fines in the process, the financial-services industry has thus far adamantly refused to curtail its long-standing policy of permitting intermediaries to mark up base rates.

So while this regulatory contest of wills presses forward, what can consumers do to ensure that the deals they make are fairly priced? By separating the profit centers and testing the pricing for each.

As important as financing is for big-ticket purchases, a good strategy would be to negotiate the sale price of the item as if you were paying cash for it. That way, you’ll be able to compare the quote you receive with the price that sites such as Consumerreports.org suggest you should be willing to pay for the car you have in mind.

Then test the dealer’s financing offer by comparing that with the local alternatives you can find online. Be sure to take both rates and fees into consideration when you compare costs.

For example, the APR for a five-year loan for $20,000 that charges 5% interest plus a $250 documentation fee is actually 5.51%. Efunda.com has an especially easy-to-use online calculator that can help you with the math—not only for car loans, but also for any other type of financing where interest rates and fees are individually quoted.

One more thing: Consumers can certainly benefit from knowing ahead of time what condition their credit is in — their credit score will, to a large extent, inform what kind of interest rate they can expect when they borrow money. They can see their credit reports for free through AnnualCreditReport.com, and can get their credit scores for free through Credit.com.

More on Auto Loans:

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  • marveleazer

    While this is certainly an entertaining piece and great Monday morning water cooler fodder, it is by no means representative of auto finance dealings. I’ve spent a career in finance from the dealer side and the numbers you’re referencing are way out of line. If dealer originated financing were so egregious then customers would avoid us like the plague. Truth is more than two thirds of consumers allow dealers to handle their financing. Either the general buying public doesn’t read or there must be a case to support financial and service products being offered by automobile dealers.

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