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Home > Columnists > Ian Ayres and Barry Nalebuff |
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Why Not?
An Educated Consumer Almost everybody knows that car prices are negotiable. But many people don't know that they can bargain with a dealer over the finance interest rate.Information is an essential ingredient of competition. That's an argument for helping customers understand the rules of the game. It's a reason even an avid believer in free markets can support laws compelling sellers to make certain disclosures to buyers.Almost everybody knows that car prices are negotiable. But many people don't know that they can bargain with a dealer over the finance interest rate. That's right. When a dealer sends your credit history to a lender, the lender responds with a private message telling the dealer the interest rate for your loan. This is what the industry calls the "buy rate." This buy rate reflects all of the risks and credit history of the borrower. Most lenders allow the dealership to mark up the rate, if it can. Nissan's finance arm allowed its dealers to add up to five percentage points. The dealer and the lender share in the extra profits from the inflated interest rate, with the dealer generally getting its share in the form of an immediate cash reward. A wave of class actions against the major automobile lenders, including the finance subsidiaries of General Motors and Ford Motor, has revealed the magnitude of these loan-arrangement fees. We are not impartial observers of the phenomenon: Ayres is a plaintiffs' expert in some of these suits. Here, we want to make the case that car buyers should be better informed about what is going on. Vanderbilt University economist Mark Cohen estimates that 10% of Nissan's borrowers had their loans marked up more than $1,600. The dealer's profit from marking up a loan can be comparable to the profit from selling the car. These markups are disproportionately borne by minority borrowers. More than half of Nissan's white borrowers paid no markup at all, while more than half of Nissan's black customers paid an arrangement fee above $750. Is this just charging higher rates for higher default risks? No. The inflated rates are not risk-based, as the markup is above and beyond the risk-adjusted buy rate that the lender sets on the basis of the borrower's credit history. The car companies say they make no racial distinctions in their buy rates. They also say that the decision about what higher rate to charge the customer--except for special rates advertised to well-qualified buyers--is up to the dealer. Even so, the manufacturers do enjoy some of those extra interest charges. Typically, they pass along 70% of the markup to the dealer and keep the rest. Dealers inflate the interest rate when they can, and because many borrowers don't realize they can bargain. It wasn't that long ago that similar games were played with destination charges. You thought you had done all of your homework and bargaining, only to be surprised with highly inflated destination charges added on at the end. That game ended when dealers were required to disclose their actual destination charge on the window sticker. Car manufacturers want happy customers, not embittered ones. Why don't they prevent their dealers from playing these games by capping the markups? Their lending arms do impose some limits, but these constraints prevent only the most egregious markups. One reason the game persists is that carmakers, as we noted, keep some of the vigorish. Another reason is that the dealer is free to get financing elsewhere. If General Motors Acceptance Corp. limits the markups on its loans, GM dealers can do car loans through the finance arms of Ford or Nissan or Citigroup. This makes it hard for a manufacturer to act alone. One exception to the rule: when a carmaker promotes its vehicles by offering 0% loans to qualified buyers. Then it won't let the dealer mark up this subsidized rate and pocket the difference. Some states have intervened. Michigan and Ohio experimented with a 2% cap on dealer markups. In these states the dealers' profits from loan arrangements and the racial disparity found are half those of the unconstrained states. In February Nissan settled a class action with a promise to put a two-point cap on the markup on most long-term loans. Nissan also agreed to a disclosure just above the signature line: "The annual percentage rate may be negotiable with the dealer." Federal law requires the sticker to disclose the true cost of the destination charge. At minimum it should also force dealers to disclose their buy rate and how much they're being compensated just for arranging a loan. We believe that the market can be efficient, but not without a healthy supply of information. Oh, and by the way, mortgage brokers are often paid to inflate your interest rate, too.
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