- One of the most significant purchases for any household is their car.
- While car prices are transparent and easily negotiable, financing deals are not. Dealers typically mark up financing offers to earn additional revenue.
- Lawmakers need to ban mark ups on auto financing and save consumers hundreds of dollars.
- Jonathan Gruber, Ph.D, is a professor of Economics at MIT.
- Tobias Salz is an Assistant Professor at the MIT Economics Department and a Faculty Research Fellow at the NBER.
- This is an opinion column. The thoughts expressed are those of the authors.
- Visit the Business section of Insider for more stories.
The COVID-19 pandemic has had a devastating impact on the US economy. Since early March, the country has lost 9,839,000 jobs. The unemployment rate peaked in April at 14.8%, the highest rate since the Great Depression, and as of January remains at 6.3%, the highest level since March 2014.
Congress has so far been unable to agree on a new package of financial relief, while unemployment insurance extensions are due to run out at the beginning of March. Americans need financial relief from wherever they can get it. Fortunately, there is a relatively simple way to provide significant financial relief to consumers on one of their most important expenditures: car purchases.
One of the most significant purchases for any household is their car. Cars are necessary for both work and pleasure, yet the cost of a car is very high relative to the income or assets of most families. The average new car purchase amounts to around half of average after-tax income. As a result, 85% of new car purchases in the US are bought with loans.
This is a significant financial obligation, with car payments amounting to around 6.5% of the income of the typical household that finances their car. As a result, lowering the costs of car purchases for American families would provide significant financial relief.
Car dealers mark up financing deals
It is common knowledge among Americans that the price of their car can be negotiated at the dealer. What is less known, however, is that the financing costs of their purchase can also be negotiated.
Dealers serve as middlemen on auto loans, with lenders providing terms to the dealers, and dealers then providing offers to potential purchasers. But dealers don’t just pass along those financing terms, they are allowed to “mark them up”.
If dealers are able to charge a higher interest rate on a loan than what was originally suggested by the lender, they receive a payment from that lender. Dealers therefore benefit if car buyers pay higher interest rates. Dealer profits from financing and insurance have steadily grown and now account for the majority of their overall profits.
Why does this matter? Because while car prices are “transparent” to the consumer and readily negotiated, financing terms are not. As a result, consumers end up paying much more for their financing than they need to. The average revenues from this “kickback” on financing new car purchases is around $750 per car. Multiplied by the number of financed new car purchases per year, this amounts to more than $8 billion in annual discretionary markup revenues.
It doesn’t have to be this way
Auto dealers can play an important role helping consumers find the proper financing. But that won’t happen so long as their financial incentives are set to benefit lenders and not consumers. Rather than playing a fiduciary role in helping consumers find the best deal for them, dealers are doing the opposite.
Congress needs to change the incentives by no longer allowing dealers to “mark up” the financing of auto loans. Regulators in other countries already have moved in this direction. The Financial Conduct Authority in the UK has announced that commissions that are linked to the customer’s price of credit are banned starting 2021. It’s time for the US to follow suit.
Auto dealers may argue that this will just lead to higher car prices — and they are right. Some of the gains that dealers make through marking up financing allows them to cut better deals on price. But the extra price reduction doesn’t make up for the higher financing markup.
When consumers negotiate over car price, they are relatively savvy, and can strike a good bargain. But when comparing financing terms, consumers face a much less transparent and confusing array of choices, and so it is harder to shop effectively.
Based on our research, consumers would save between $300 and $500 on each new car purchase without dealer markups. That is roughly $5 billion in financial relief to US consumers that we can provide with a simple regulatory change.
Consumers face a bewildering array of choices in their everyday lives. An important innovation in recent decades is the rise of middlemen that can help organize these choices and allow consumers to shop more effectively. But the benefits of these middlemen can be offset if there are financial incentives against offering a neutral playing field for consumers to find the option best-suited for them.
Choosing how to finance a car is a perfect example — and an easy one to fix. Lawmakers need to ban markups on auto financing to make car purchases less burdensome for consumers — at exactly the time when US consumers could use the relief.
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