New cars are seen lined up at a dealership in Peabody, Mass. Monday, Jan. 5, 2009.

The Hidden Cost of Car Loans

Car dealers are cheating buyers by failing to disclose interest rate markups.

New cars are seen lined up at a dealership in Peabody, Mass. Monday, Jan. 5, 2009.

Banks that fund car loans have the power to stop abusive markups, but they aren't rushing to change.

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Buying a car is one of the largest purchases American consumers will make in their lifetime, but getting a loan through the dealer is also one of the least transparent financial transactions. One particularly murky practice is dealer interest rate markups — hidden, discretionary costs added to the loan.

When a car buyer finances a car through a car dealer, he or she signs a contract with the dealer for the car purchase and loan. In the vast majority of cases, the dealer will quickly get funding for the loan by selling that contract to a third party, such as a bank or finance company. The potential funders also receive the consumer’s financial information to help them determine pricing on the loan. The dealer then collects bids from interested financial institutions, which outline the terms and conditions the funder will accept, including the interest rate.

What most car buyers don’t know is that the bank funding the loan allows the dealer to increase the interest rate for compensation. For example, a bank may be willing to buy the contract as long as the interest rate is at least 4 percent, but will permit the dealer to charge the consumer up to 6.5 percent interest. The dealer is paid some or all the difference, which is the “markup.”

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The Center for Responsible Lending estimates that for dealer-financed cars bought in 2009, over the life of their loans buyers will pay $25.8 billion in interest solely attributable to this markup. In 2009, the average markup was nearly 2.5 percent, hiking costs for each loan by hundreds of dollars. While we believe dealers should be compensated for the work they do in financing cars, they shouldn’t have arbitrary discretion to take more in compensation from some buyers than others.

Unfortunately, a long trail of cases shows that the dealer system is patently unfair. Most recently, the Consumer Financial Protection Bureau and the Department of Justice announced a settlement with Ally Financial based on discriminatory markup practices. They found that the average African-American car buyer who received an Ally loan paid more than $300 in additional interest over the course of the loan than white borrowers with similar qualifications. While agreeing to pay $98 million to settle these claims, Ally has also said that it plans to continue granting dealers the discretion to manipulate interest rates for compensation.

The dealers’ stubborn clinging to the markup system persists in spite of a history of legal violations dating back to the late 1990s. Again and again, lawsuits and investigations have found pricing discrimination. Not only do car buyers of color receive interest rate markups more frequently, they also consistently get higher markups than similar white borrowers.

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The National Automobile Dealers Association recently proposed a voluntary plan for its dealers. Under this plan, rather than increase the interest rate on a case-by-case basis, dealers would mark up every interest rate. But here’s the catch: Dealers would still be free to lower rates if they so choose. This means that certain groups of consumers could still find themselves paying unjustifiably higher interest rates.

Dealers also try to justify markups by saying that their customers can negotiate the interest rate on their loan just like on the price of the car. The problem is this: Negotiation on interest rate doesn’t result in better pricing.

The Center for Responsible Lending recently released data showing that even though borrowers of color reported negotiating their interest rates at the same rate or more than white borrowers, they still paid higher interest rates. The data also showed that borrowers of color were more likely to be told information leading them to believe that further negotiation would be fruitless. When the dealer tells a consumer that the interest rate is the best that dealer can find, even though that may not be true, the consumer stops negotiating.

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Ultimately, the banks that fund these loans have the power to stop abusive markups, but, as with the dealers, they don’t seem to be rushing to change. Recently, Wells Fargo announced that it will continue to allow dealers to mark up interest rates for compensation.

The Center for Responsible Lending and other groups believe that this particular form of compensation, which has a long history of unfairness, should be eliminated. Dealers already get compensated in forms other than marking up the interest rate. For instance, dealers receive a flat fee for every loan made under 0 percent and other low-interest rate promotions that manufacturers may offer. Dealers will still get compensated for their work, but with less incentive to sell consumers on the highest interest rate possible.

We applaud the Consumer Protection Bureau and Justice Department for their vigilance and action on the abuses that dealer interest rate markups cause. We think their recent actions are a step in the right direction, but we know that the only way to effectively eliminate abuse is to end this practice.