When you consider that the airline industry made it easy to compare options decades ago, it is shocking how antiquated the auto financing experience still is. Auto financing has somehow managed to evade many of the technological advances seen elsewhere.
Auto manufacturing, purchasing and lending are key drivers of the U.S. economy. Last year, Americans bought more than 17 million vehicles. The scale of this market is largely made possible by auto loans. Over 85% of new cars were financed in 2019.
It is shocking to find that such a valuable financial service is still marred by inefficiencies and a lack of consumer transparency that other industries have already overcome. There are four key consumer problems with the industry: price dispersion, inconsistent risk-based pricing, high search costs and dealership markups.
Problem 1: Price Dispersion
Price dispersion is a fancy way of saying that consumers pay different prices for the same product. Most auto lenders claim to base rates and terms on the credit profiles of borrowers. In other words, all things being equal, a borrower with a higher credit score should qualify for a better rate. However, research indicates that auto loan pricing is much messier.
According to a 2017 study of 2.4 million auto loans by 326 different financial institutions in 50 states, 54% of auto loan borrowers did not get the lowest interest available to them. The researchers examined borrowers with the same loan term, car value, debt-to-income ratio, commuting zone and origination zone. They found the average borrower paid an interest rate that was 1.3 percentage points higher than the best rate available. In other words, most borrowers pay more than they need to just because they don’t know they have better offers available.
Problem 2: Inconsistent Risk-Based Pricing
A related issue is that the FICO credit score brackets lenders use in their risk-based pricing models are inconsistent. Lenders often determine the rates of a borrower based on threshold FICO credit scores. For example, a borrower with a credit score above 600 may get a better rate than someone with a 595 FICO but no different than someone with a 690 FICO. However, another lender may have completely different threshold scores. The study mentioned above found that on average, borrowers got a rate that was 1.46 percentage points lower than a similar lender that had a credit score just below the FICO threshold.
The takeaway here is that shopping at multiple lenders is crucial if you want to get the best price available. It also means you can’t rely on the interest rate range lenders advertise. You need to check your rate before you know if a lender offers the best rate available.
Problem 3: High Search Costs
As you would expect, people with fewer options are more likely to accept an auto loan with a high interest rate. For instance, people who live in banking deserts where there is not a wide selection of lenders, such as rural areas, tend to accept higher rates. According to the study cited above, a borrower in an area with a high search cost will, on average, buy a car that is three months older and worth $700 less.
Other search costs that make the auto financing market inefficient are slow approval processes, time-consuming paperwork and concerns on the impact credit inquiries will have on borrowers’ credit scores.
Problem 4: Expensive Markups From Dealerships
Buyers are more sensitive to the price of a vehicle than financing charges. A 2019 study found that consumers are willing to pay $1 more in finance charges for every $0.86 reduction in the vehicle’s price.
Dealerships know this and use it to their advantage when offering buyers financing. For example, a dealer may reduce the price of a car to a buyer who finances it through the dealership because it more than covers the difference with the financing markup. The research cited above notes that car prices would drop by $350.25, on average, if dealers didn’t have the discretion to change the price of loans.
Another problem is that many consumers don’t understand the effect of auto financing on the total cost of buying a car. A survey by the Federal Reserve reported that 76% of buyers haggled with the seller on the price of the vehicle, but only 31.6% negotiated the interest rate on their auto loan.
Even when borrowers think about the cost of financing, they tend to focus on the wrong metrics. The same Federal Reserve survey found that 27% of buyers considered the cost of the monthly payment as the most critical factor. But only 6.1% thought the interest rate was the most important factor.
Disruption Is Coming To Auto Finance
The good news for consumers is that these are solvable problems. Third-party websites like TrueCar and Cars.com have made the pricing of cars more transparent, and more and more lenders now allow borrowers to prequalify for loans without dinging their credit. Instead of accepting whatever rates dealers offer, which often include steep markups, buyers can negotiate their own terms. Platforms like the one my company supplies are also making it easy to compare rates by providing real-time preapproved offers from multiple lenders.
For consumers, these services are typically free to use. So it's a good idea to try multiple services to see if one is able to find a better deal than another. With the right amount of research and testing, you may find the right platform for you, your family or your organization.
