Auto Loans’ Quiet Catastrophe
Two Hidden Causes and a Simple Solution
Regulatory loopholes and dramatic shifts in auto dealership business models are driving a catastrophe in auto finance. We’ll explain what’s happening and offer a simple solution.
What auto loan catastrophe?
An auto loan crisis is brewing under the hood. A record seven million Americans are 90 days delinquent on their auto loans, putting them in danger of having their cars repossessed and their lives upended.
That’s almost 1.5 million more auto loan delinquencies than the prior peak following the financial crisis of 2008, according to a February 2019 report from the Federal Reserve Bank of New York. That’s strange, given the overall strength of the economy. Both credit card and mortgage delinquencies are at 15 year lows. Unemployment is hovering around 50 year lows. So why are so many people struggling to make their car payments?
Two hidden causes
Two poorly understood factors go a long way to explaining this disconnect. Both factors focus on auto dealerships, where 80% of auto financing is arranged. First is a regulatory loophole created for the benefit of dealerships. Second is that auto dealers now make more money from selling financing than they do from selling cars: the average dealership markup on a new car is nearly $1,800. Taken together, these two factors explain why so many car owners are in trouble – and help point the way toward a solution.
“Exclusion for Auto Dealers”
We did not coin that phrase, but it is the first hidden cause of the auto loan catastrophe. The legislation put in place after the mortgage crisis, called the Dodd–Frank Wall Street Reform and Consumer Protection Act or “Dodd Frank” for short, was intended to promote transparency in the financial system and “to protect consumers from abusive financial services practices.” According to Christopher Dodd, then the senator from Connecticut who introduced the bill, “Dodd-Frank is a comprehensive solution to a comprehensive problem.” Despite the scope of the act, it contains a curious section, titled “Exclusion for Auto Dealers.” The provision states that regulators empowered to enforce the act “may not exercise any rulemaking, supervisory, enforcement or any other authority over a motor vehicle dealer.”
This means that consumers taking auto loans arranged by auto dealerships do not enjoy the same protections as consumers taking out mortgages. For example, companies that originate consumer mortgages cannot receive undisclosed payments from a bank or finance company, cannot receive a bigger fee if they convince the borrower to take a longer term loan, and must verify that a borrower will be able to repay their loan – or be held responsible in a foreclosure. Auto dealers have no such obligations, even as they are responsible for originating 80% of new car loans in the US – over 8 million car loans last year.
The unfortunate result is a repeat of many of the aggressive lending practices that drove the mortgage crisis, only now in the next biggest asset class: cars. Auto loan terms are lengthening from the traditional 60 month term to nearly 70 months at last count. And the percent of vehicles being traded in with negative equity on their car loans has topped 30%, according to Matt Jones at Edmunds Data.
Auto loans are the new profit center
A second poorly understood phenomenon is the dramatic shift in how auto dealers make their money. The proliferation of car shopping websites has improved price transparency. With the click of a button, we can now figure out the average price our neighbors paid for their cars and we can see whether we can do better. As a result, car dealers actually make less gross profit from car sales than they did in 2010.
How you pay is even more important than how much
While transparency has brought efficiency to the price we pay for our cars, the lion’s share of auto dealer profits are now made where transparency, information, choice, competition, and disclosures are limited: the financing “back office.”
It should be a truism that the back office of a car dealership is the wrong place to make important financial decisions, but that is where 80% of new cars are financed. Since 2010, the amount of profit earned by auto dealers for financing vehicles has doubled. In 2018, auto dealers earned more money from car finance than from car sales, as we demonstrate in the Outside Financial Auto Dealer Profit Watch.
The average auto loan markup reaches $1,788
Auto dealers earn profits from auto loans in two ways, neither of which are disclosed to car buyers. First, auto dealers can mark up the interest rate on the loan. Imagine that the bank tells the dealer they’ll finance a given customer for 5%, known as the “buy rate.” The auto dealer can then tell the customer their loan will carry a 6% interest rate, known as the “contract rate.” The dealer is able to pocket most of the difference between those two rates. And the difference amounts to a $1,000 markup on the average new car loan.
In auto finance circles, it is a tongue-in-cheek line that the bank’s customer is the auto dealer, not the car buyer. That’s because in the back office, the auto dealer controls which bank’s offers are presented, often based on what’s best for the dealer, not for the customer.
The second component of the dealer’s profit is the markup on vehicle and credit protection products like VSCs (aka “extended warranties”) and GAP waivers. Again, the dealer is under no obligation to disclose any of these fees or markups And customers rarely shop around for these products or even realize they can be purchased outside the dealership.
We calculate in the Outside Financial Auto Loan Markup Index that dealer markups on auto loans have risen by more than 60% to $1,788 from 2010 to 2018. These markups are typically not paid out of pocket, but are rolled into the principal amount of a loan. In other words, while the average car buyer might drive 50 miles to save $500 on the price of a car, they could save a lot more by shopping around for a loan package, where they can overlook fees and markups if they are not paying close attention.
Hazardous blind spots
Why does this happen? People usually shop for cars, not for car loans. Many consumers are not even aware that they can bring financing from outside the dealership. And a full 68% of consumers do not realize that auto dealers can mark up the interest rates on their loans, according to a report from the Center for Responsible Lending. To top it off, most consumers are not aware that they can refinance a car loan if they didn’t get the right deal the first time.
A solution as simple as grocery shopping
Just like most people don’t go to a grocery store not knowing how they’re going to pay at the checkout line, car buyers shouldn’t go into the dealership without understanding their car loan options. The dealership can be the right place to shop for a car, but it’s not the right place to shop for a car loan. And if car buyers get the wrong loan, they need to know their options to refinance.
We created to level the playing field for consumers. We believe that a new paradigm is needed in the car loan industry – one that serves the best interests of the borrower, not the auto dealer, not the bank, not the car makers.
The quiet car loan catastrophe is about much more than statistics. Cars are the second most important purchase that most of us will ever make, and are critical to getting us to the places we need to be. That’s why we have tools to ensure car buyers and owners can understand their options and make great auto financing decisions “Outside” the dealership.
Share if You Care
What if the innovation, information, and competition that have transformed so many pockets of our financial system existed for auto loans too? It’s time for the auto finance industry to change, and that’s what we’re here to do. If you agree, please share this article and encourage your friends and family to visit www.OutsideFinancial.com to learn more.