There is a dirty little secret of auto financing. Because of some legal jargon (dealers are technically selling to lenders retail installment contracts as a broker between the consumer and the lender), dealers are able to represent consumers in negotiations with the lender. Because they have one interest in heart (their own), they have worked an agreement between lenders and dealers called “dealer participation.”
Dealer participation is offering a cut of the loan’s profitability to the dealer for negotiating terms more favorable to the lender (often in case of a flat fee, given that the borrower doesn’t charge off in 9 months – a practice known as buybacks).
It works like this:
Dealer takes consumer information (credit history, credit score, amount down, make, model, mileage, location, etc.) and submits it to a lot of banks. Those banks come up with a lot of offers in an attempt to win the dealers’ (not the consumers’) interest. Whichever one the dealer can sell to the consumer is the one they will take.
Lenders will offer higher APR loans with profit-sharing (dealer participation, in the form of a flat fee) to the dealers in order to entice them to give worse loans. A 4% loan with profit sharing will be more profitable for the dealer than a 2% loan without.
I am a great consumer. I have a 740 FICO, I have $4,000 to put down and I am looking for a reasonable used 2013 Nissan Altima with 44,000 miles on it for. A reasonable commuter car. After sitting down with the dealer and negotiating sales price (always negotiate sales price and not monthly payment!), he hurriedly grabs your information and rubs off into the back room. You think based off of market rates and the reasonableness of your deal that you can secure a 5.0% APR. On a $20,000 loan with 60 months, you would have to pay $377 a month.
A beautiful receptionist comes out and offers you coffee and water. You sit around outside sweating wondering if you’ll get approved. What is going on back there?
A free-for-all has started. The second he went back there he sent the information to eight different banks and credit unions and they are in a mad hurry to get your business. Dealers usually expect an approval in 10-15 minutes (although most banks besides Wells Fargo have it within 2 minutes).
Two enticing offers came across the table. One with a 2.0% APR and no fee for the dealer. The other one is for 4.0% APR with a $700 kickback for the dealer. Here’s where he plays some mental gymnastics.
He comes out of the backroom smiling. Excitedly, he shows you the 4.0% APR at the exact terms you were looking for: 60 months and $20,000. $368/month! I just saved $9/month (dealers will use this opportunity to lump in warranties to make it seem even cheaper than it really is). The reality is that if you had received the 2.0% APR that one bank had offered you would only have had to pay $351/month. Every month, you are paying an extra $17/month in interest that you didn’t need to pay.
Consumer is happy he got lower APR than he expected. Dealer is happy because he secured an extra $700 bonus for his bosses. Lender is happy because he got the loan at 4.0% APR instead of 2.0% APR. Win, win, win. Right?
The consumer is paying more than he had to on the same exact loan. It may not seem like much, but that $17/month over 60 months is an extra $977 that the consumer is paying into the system.
Information. Know your APR. Do research. If you are bringing money to the table, have sufficient income and a good credit report, you should be able to obtain rates similar to national average. There are many options online to provide up-to-date auto finance APR averages.
You can also obtain financing outside of the dealership. Remember the dealer has five major functions, all of which are replaceable by another third party:
For financing options, a common tactic is to get an approval from a credit union or directly from a smaller bank. If you know that you have an offer for 3.0% APR in your hands as you walk in the door, you can tell them to beat it. If they can’t beat it, great, you go with the 3.0% APR. But if they can beat it, then it means more money for you!