Get a Car Loan Through the Dealer? Could Mean an $1,800 Penalty
How to end-run a system that lacks transparency.
With the average price of a new car nearing $40,000, it’s the rare household that can pay cash to buy a new car outright. More than eight in 10 households either take out a loan or lease.
If you’re aiming for a loan, shopping for the best deal has never been more important. With the average new-car loan now north of $36,000 according to Experian Automotive, this is not some small-ticket endeavor.
Tip #1 is to actually shop around. Yet that’s not what most new car buyers do. Experian says arranging financing through the dealership has never been more popular. Convenient? Absolutely. Potentially more costly than arranging financing directly through a bank or credit union? Absolutely.
When you walk over to the financing desk at a dealership, or strike up an online relationship, you need to understand that in many instances you are about to negotiate with someone who basically is working as car-loan broker. And brokers collect commissions.
What typically happens is that the car finance person zaps your loan particulars (amount you want to borrow, your credit score, etc.) to a handful of banks and finance companies and tells them to make a bid. Those lenders will quickly come back with a “buy rate.” That’s the base interest rate the lender will do the deal at.
But here’s where that commission comes in. The friendly finance person you’re sitting across the desk from, or emailing with, is then legally allowed to increase that interest rate. A recent National Bureau of Economic Research study that pored over a massive database of car loan deals found that when the dealership is acting as the middleman, nearly 80% of loans are marked up. (Technically, mark-downs are allowed too, but less than 1% of dealer-financed loans came with that incentive.)
Typically the markup can be as much as 2 to 2.5 percentage points, with the majority of the increased value of the loan going straight into the pocket of the dealership. The average total markup in the recent academic deep dive was more than 1 percentage point. An earlier paper estimated the average extra charge over the life of a loan, due to a markup, was nearly $1,800 in 2018. That’s a lot to pay for convenience.
Depending on the car you choose, you may run into another form of dealer financing: The loan comes directly from a subsidiary of the car manufacturer. In those situations, you don’t have the interest-rate mark-up to deal with, as your loan application isn’t being shopped around to multiple lenders. In fact, if you’ve got a great credit score, this is where a zero-interest rate financing deal might be offered.
Clearly, if you can qualify for a zero rate, that’s likely a good deal. But be careful. If you went in with the intention of buying a certain make and model for say $30,000, and the zero rate is only offered on a different make and model with more bells and whistles that pushes the price to $35,000, you’ve just bought more car than you needed.
So, shop around instead. It’s never been easier to get an online auto-loan pre-approval from a credit union or bank. Get a pre-approval or two ahead of actual car shopping. If the dealer can beat the terms, great.
One potential trap: Lenders will tell you the maximum you can borrow. That’s no way to decide how much to spend.
If you have yet to build up an emergency fund, or your retirement savings is on the light side, or you keep telling yourself you will never be able to buy a house, those are all data points that suggest you really should borrow the least amount possible on a car. A monthly car loan that is $350 rather than $550 (the recent average for a new car loan), is $200 a month you have for those other goals.
Even better, consider a used car. A car that is just three or four years old still has many years of reliability ahead of it, and you’ve effectively avoided the three or four most costly years of car ownership. New cars depreciate about 40% to 50% over those initial years. Let someone else — the prior owner(s) — pay for that.