A car, second only to a home, is one of the most expensive purchases most Americans make. Financing such a purchase is one of the least transparent financial transactions—a landmine of lending abuses, especially by car dealers who handle financing. Although some highly questionable business practices in the auto industry are now legal, federal regulators are considering new rules that would make car loans more fair and affordable.
Most consumers today can access information on car prices, but determining whether the cost of a car loan is fair is much more difficult for consumers, especially if the consumer has a low income and an impaired credit. When financing through an auto dealer, consumers must evaluate a web of loan terms and consider sales pitches for add-on products, such as extended warranties and optional insurance. Car buyers are asked to choose from a dizzying array, and the wrong choice can have a significant financial impact.
Because the Internet has made information on car pricing readily available, dealer profit margins on their main product—the car itself—are declining. According to a recent report, “new car sales account for less than 20 percent of dealer margin in the [United States] and often even have negative returns, but financing and warranties are becoming even more important as sources of dealer income.”1 Car dealers now rely more heavily on the finance and insurance office to generate profits than in the past.2
The complexity of car buying combined with changing dealer incentives has created an environment ripe for consumer abuses.
The complexity of car buying combined with changing dealer incentives has created an environment ripe for consumer abuses. In recent years federal regulators have focused increasing attention on auto financing—in particular, the practices of car dealer interest rate markups and “yo-yo” scams.3 These practices drive up the cost of car loans significantly, yet most consumers drive away with no knowledge about interest rate markups and yo-yo scams, both of which put a buyer at greater risk of defaulting on an expensive loan.
The Center for Responsible Lending found that consumers who financed their cars through dealerships in 2009 paid $25.8 billion in hidden dealer interest rate markups over the lives of their car loans.4 Here I describe car dealer interest rate markups and yo-yo scams, the legal issues surrounding them, and regulatory actions that could strengthen legal protections for car buyers.
The Mechanics of Buying a Car
There are different types of car dealers. Franchise dealers are affiliated with a manufacturer to sell new cars and often operate a used-car lot in the same facility. Independent used-car dealers, by contrast, sell only used cars and have no affiliation with a particular manufacturer. Independent used-car dealers finance cars and sell their auto loan contracts to financial institutions unaffiliated with the dealer.5 Another class of dealer is the buy-here/pay-here dealer, retaining and servicing the finance contract. Here I exclude buy-here/pay-here dealers.
The first person a consumer meets at a dealership is usually a salesperson, who helps the buyer select a car. At some point the salesperson may ask whether the consumer is interested in financing with the dealer and offers to speed up the loan process if the consumer gives information that allows the dealer to assess financing options. To collect the information, the salesperson uses a form with a section authorizing the dealer to access the consumer’s credit report if the consumer signs the form.
While gathering the information, the salesperson negotiates the price for the car, how much the dealer will pay for a vehicle the consumer may wish to trade in, the amount of a down payment, and any options and features the consumer may wish to purchase.
The consumer chooses loan terms and whether to buy insurance and protection products and signs documents related to the sale or financing or both of a car in the finance office.6 The agreement to purchase the car is called the “buyer’s order.” Car financing contracts are retail installment sales contracts and should follow the requirements as set forth in the Retail Installment Sales Act of the state where the car is sold.
The retail installment contract lists the dealer as the creditor, and the finance agreement is between the dealer and the consumer. The dealer then arranges to sell the contract to a bank, finance company, or credit union. Most dealers finance the inventory they hold and in most cases must pay off the financing with each car sold. If the floor-plan financing is not paid off, then the dealer may not have the cash available to purchase new inventory. Thus the dealer wants to sell the finance contract quickly.
After collecting the financing information from the consumer, the salesperson forwards the information to the dealer’s finance and insurance office. While the consumer negotiates the terms of the sale, the finance manager (or business manager) solicits offers from financial institutions interested in purchasing the finance contract from the dealer. Most finance sources operate electronically, and offers to purchase the contract usually arrive quickly when the financing is relatively straightforward.
Even if the consumer asks the dealer whether the loan includes an interest rate markup, the dealer has a legal shield that allows the dealer to conceal that information.
Car Dealer Interest Rate Markups
Financial institutions interested in purchasing a car loan contract send the dealer a bid to purchase the contract, which includes the terms and conditions the financial institution will accept. The terms and conditions include the interest rate—also known as the buy rate—at which the financial institution will purchase the contract. Many financial institutions let the dealer decide whether to add to the interest rate and keep as compensation some or all of the net present value of the difference in interest collected. Dealer interest rate markup is known as “dealer reserve” or “dealer participation.”
For example, Bank A states that after a review of the consumer’s credit score and other available data, it is willing to purchase the installment contract for 6 percent interest. Bank A also specifies that the dealer may include dealer participation of up to 2.5 percent. Under this arrangement, Bank A will allow the dealer to charge the buyer up to an 8.5 percent interest rate.7
As mentioned, the Center for Responsible Lending estimates that dealer markups cost consumers nearly $26 billion in additional interest.8 This does not mean that the compensation is unjustified; however, this figure shows that markups are a significant source of auto dealer income. Advocates should understand that the interest rate markup system as currently practiced creates an incentive for a dealer to sell a consumer the most expensive loan instead of a loan that best meets the consumer’s needs.
The Interest Rate Markup Operates as a Hidden Fee
As soon as the consumer accepts a loan offer from the dealer, the consumer is presented with a retail installment contract that sets out the terms of the loan. This contract does not disclose the portion of the interest rate that will be given to the dealer as compensation for making the loan. Instead the retail installment contract is a long sheet with fine print on both sides detailing all the terms of the contract. That the dealer might be receiving compensation in exchange for selling the contract to a financial institution is generally explained in a vague disclosure.
Some states mandate the form and wording of the disclosure. For instance, North Carolina requires that
[t]he dealer shall disclose conspicuously on the purchase order or buyer’s order, or on a separate form provided to the purchaser at or prior to the closing on the sale of the vehicle, that the dealer may receive a fee, commission, or other compensation for providing, procuring, or arranging financing for the retail purchase or lease of a motor vehicle, for which the customer may be responsible.9
Some dealers use contracts that make the consumer aware that the interest rate may be negotiable. The consumer cannot possibly know from this disclosure whether the dealer received compensation for the loan, and, if so, what portion of the interest rate reflects the risk the consumer presents versus the portion of the interest rate the consumer is paying for the dealer’s services.
On this point the North Carolina law protects the dealer from having to disclose that information:
Nothing contained in this section or elsewhere under the law of this State shall be deemed to require that a motor vehicle dealer disclose to any actual or potential purchaser the dealer’s contractual arrangements with any finance company, bank, leasing company, or other lender or financial institution, or the amount of markup, profit, or compensation that the dealer will receive in any particular transaction or series of transactions from the charging of such fees.10
As such, even if the consumer asks the dealer whether the loan includes an interest rate markup, the dealer has a legal shield that allows the dealer to conceal that information.
Interest Rate Markups Have a Long History of Discriminatory Impact
Starting in the late 1990s, attorneys filed a series of class action lawsuits against the largest auto finance companies in the country; they alleged violations of the Equal Credit Opportunity Act.11 In particular, the suits alleged that African American and Latino car buyers were more likely to have the interest rate on their car loans marked up and to pay higher markups than their similarly situated white buyers.
Data from some of those cases indicated that the allegations had merit.12 All the cases settled, but the settlements did not eliminate dealer interest rate markups. Rather, the cases imposed caps of 2 percent to 2.5 percent—meaning that those finance companies could not permit car dealers to add more than 2 percent to 2.5 percent to the interest rate on a car loan.
The Consumer Financial Protection Bureau’s guidance to its supervised lenders, who purchase auto loan contracts from auto dealers, reminded lenders that, under the Equal Credit Opportunity Act, financial institutions buying auto loan contracts from dealers could be held liable for any Act violations, including disparate impact on protected classes.13 The bureau would examine an institution for potential violations not only within the loans purchased from a particular dealer but also across the institution’s full portfolio of loans.14
According to the Consumer Financial Protection Bureau, “[b]ecause of the incentives these policies create, and the discretion they permit, there is a significant risk that they will result in pricing disparities on the basis of race, national origin, and potentially other prohibited bases.”15 For that reason, the bureau cautioned lenders to take steps to prevent disparities both in the loans purchased from individual dealers and in loans held across the lender’s portfolio. Otherwise those lenders could be held liable for discriminatory impact under the Equal Credit Opportunity Act.16
According to a Consumer Financial Protection Bureau and U.S. Department of Justice consent order with Ally Financial Incorporated over allegations of disparate impact among borrowers of color represented in Ally Financial’s auto lending portfolio, African American, Latino, and Asian/Pacific Islander consumers paid between 20 and 29 basis points more in interest than their similarly situated white peers.17 Recent Center for Responsible Lending research indicates that active negotiation between a nonwhite consumer and a dealer may not affect the interest rate a buyer receives.18 In a recent survey of 960 consumers who recently purchased cars, the center found that even though African American and Latino consumers were more likely to report their attempts to negotiate the interest rates, interest rate disparities persisted.19 Further, those consumers were more likely to report that the dealer misled them that the interest rates quoted were the best they would receive.20
The Interest Rate Markup Is Like the Now Prohibited Mortgage Broker Compensation
Dealer interest rate markups are similar to a compensation system in mortgage lending until the system was prohibited by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.21 Mortgage brokers had been compensated, in part, through the interest rate, called a yield spread premium.22 Under this system a broker earned additional compensation for selling a higher interest rate. In some cases the increase in interest rate was used to pay for up-front charges related to the mortgage. In many other cases, however, the compensation was an incentive for the mortgage broker to sell the consumer a loan with worse terms than those for which the consumer would ordinarily qualify.23
The markup on car loans operates similarly. The customer is unaware that the dealer will benefit financially if the customer pays a higher interest rate or that the loan has a higher interest rate than the rate for which the borrower actually qualified.24 And, like mortgage brokers, dealers routinely represent that they use several sources to find credit for consumers.25 Such representations give consumers the false impression that dealers are shopping on the consumer’s behalf rather than maximizing the dealer’s own compensation.
In some cases, particularly when a consumer has a credit offer at a lower interest rate than the dealer is prepared to offer, the dealer forgoes some or all of the dealer’s compensation to make the interest rate equal or slightly less. In order to make up for the lost profit, however, the dealer raises the price on the car, lowers the amount for the trade-in, or pushes harder to sell add-on products. For the consumer, there is often a trade-off in accepting the dealer’s lower interest rate, but usually the consumer cannot know where the trade-off is.
A second abusive practice is the yo-yo scam. This scam occurs when a dealer allows the consumer to leave the dealership with the car before the financing is final—a practice more common than most people realize. The dealer contacts the buyer days, weeks, or months later and asks or demands that the buyer bring the car back to the dealership; the buyer is told that executing another financing contract is necessary. The new contract may have a higher interest rate or down payment or other changes that require the consumer to pay more. The consumer is reeled back into the dealership like a yo-yo on a string.
Conditional Delivery Is Used to Introduce a Less Favorable Contract Later
Financial institutions routinely purchase car loan contracts from dealers. Before the advent of computers, dealers seeking to sell their contracts had to talk with a representative of a finance source or communicate via fax with the lenders with whom the dealer did business. Many times, however, those finance sources were closed after hours or on weekends. Often the consumer’s own financial institution would be closed when the consumer sought to purchase the car, and the consumer could not secure financing that day.
Car dealers know that the more time a consumer thinks about the purchase of a car, the less likely the deal will be closed. For that reason, dealers allow the consumer to leave with a car on a conditional-delivery agreement, also called a “spot” delivery. Under this agreement, if the dealer is unable to secure financing or the consumer cannot secure financing or both, then the consumer must return the car.
Today most communications between dealer and financial institutions are electronic, and credit decisions can be made any time of day.
Today most communications between dealer and financial institutions are electronic, and credit decisions can be made any time of day.26 In most cases dealers have an agreement with a lender to sell the credit contract before the consumer leaves with the car, although there may be some legitimate reasons why the credit contract sale may not be final. For instance, a financial institution may condition the purchase of the credit contract on proof of income or verification of employment status. But such stipulations are transmitted with the offer to purchase the contract, and the dealer is well aware of them. Relatively rare is an offer to purchase the contract that cannot be secured the same day, and that is usually because the consumer’s credit profile is such that a credit analysis takes longer to complete.
Notwithstanding that many deals can be finalized the same day, most dealers make dealer-financed transactions conditional-delivery agreements.27 Most dealers include a disclosure either in or attached to the finance contract that if the dealer cannot sell the credit contract on terms acceptable to the dealer, then the dealer can void the contract and require that the car be returned. In some cases the contract clause stipulates that the dealer may charge the consumer a rental fee for the use of the car and charge for additional wear and tear on the vehicle.28 In some cases the dealer does not include the clause at all and still asserts the right to cancel.
Most finance sources operate electronically, and offers to purchase the contract usually arrive quickly when the financing is relatively straightforward.
Only one-third of states have statutory requirements for conditional-delivery agreements. For example, North Carolina requires that the car remain on the dealer’s insurance policy and that the consumer be given dealer license plates rather than temporary license plates.29 Such requirements ensure that the conditional delivery is temporary and that ownership of the car is not transferred to the consumer. Frequently dealers disregard these requirements, and this leads consumers to believe that the financing agreements are final.
Rental or wear-and-tear fees, along with other tactics, are leverage that a dealer uses to convince the consumer to sign a new, less favorable credit contract. Many yo-yo cases involve the dealer refusing to return a vehicle that the consumer traded in or any down payment the consumer made or both. In more extreme cases consumers who refuse to return the vehicle to the dealer find their car repossessed or are threatened with prosecution.30
Legal Issues Surround Yo-Yo Scams
Conditional delivery allows any car loan to be a potential yo-yo transaction. Either the dealer fails to take steps showing that the dealer retains ownership until certain conditions are met, or the dealer adds clauses to the contract delaying transfer of ownership until the dealer decides that the transfer is final. Both “methods” used by dealers violate common requirements for a contract to be fulfilled: conditions precedent and conditions subsequent.
In a condition-precedent transaction, a car remains in the car dealer’s ownership under a bailment agreement. The consumer does not take ownership of the vehicle until the condition precedent is met, in this case when the dealer agrees to accept an offer to purchase the finance contract.31 The aforementioned North Carolina statute contemplates this structure—the car must remain on the dealer’s insurance policy, and dealer tags must be used to make clear that the consumer does not yet own the car. However, a dealer representative for a prominent car dealer in North Carolina admitted that none of the conditional-delivery transactions the dealer entered into complies with this North Carolina law.32
In a condition-subsequent transaction the dealer transfers ownership to the consumer, but the contract states that the financing contract may be rescinded if the dealer decides not to sell the contract to a finance source. However, many dealers also include language that allows the dealer to charge a rental or usage fee for the consumer’s use of the car, and this implies that the dealer still has an ownership interest in the car while the consumer is in possession of it. In other situations the dealer does not begin transferring the title of the car to the consumer until the contract is final.
Conditional-delivery agreements also evade the intent of the Truth in Lending Act, which allows consumers to compare the costs of credit.33 The key to the Act is that the offer the consumer receives is a firm offer of credit, the terms of which do not change once the offer is made. In the current auto lending environment, virtually no credit offer is a firm offer. Moreover, the dealer reserves the right to cancel the contract days, weeks, or months after the consumer takes possession of the car.
The rampant use of conditional-delivery clauses has shifted the profit risk from the dealer to the consumer.
Conditional Delivery Shifts Risk to the Consumer
The rampant use of conditional-delivery clauses has shifted the profit risk from the dealer to the consumer. A dealer completes more transactions in a day than most consumers will undertake in their lifetimes; this means that dealers have the past experience and information to know whether a particular consumer’s loan will be easily sold to a third party. Remember that most conditional sales are predicated on the dealer’s decision on whether the agreement to sell the contract is to the dealer’s liking. Whether the dealer accepts the deal before the first payment is made or the dealer calls on the consumer to sign a new contract is impossible for a consumer to know.
Furthermore, the dealer has significant leverage over the consumer. The dealer holds the consumer’s down payment and trade-in vehicle and in many cases will refuse to return them. Some dealers also insist on charging a rental fee or usage fees, which can total hundreds, if not thousands, of dollars. If the consumer has a lower credit score, the dealer tells the consumer that the “lender” turned the consumer down even though the dealer decided not to sell the contract.
Despite this asymmetry of information and bargaining power, regulators have allowed and courts have upheld the car dealer’s requiring consumers to pay more in financing costs. The frequent use of conditional-delivery agreements in effect creates an insurance policy for the dealer. When a dealer finds itself with a credit contract that it cannot sell at a favorable level, the dealer simply voids the contract rather than take a loss on the transaction and demands that the consumer sign a new contract. In any other retail context the retailer, unsatisfied with the terms of the deal, is not allowed to call upon the customer to pay more for the item after the customer takes the item home.
Policy Considerations for Regulators
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, supervision of automobile finance transactions is split between the Federal Trade Commission (FTC) and the Consumer Financial Protection Bureau.34 Under the Act the FTC retains direct authority over car dealers and can pursue regulatory changes through the Administrative Procedure Act rather than the more cumbersome Magnusson-Moss rulemaking.35 The franchise car dealers—those affiliated with a manufacturer and given the franchise right to sell new cars—lobbied for and received an exemption from direct bureau oversight and supervision, as did larger used-car dealers with service departments. The bureau, however, currently has jurisdiction over large lenders buying auto contracts from dealers. The bureau has yet to issue a “larger participant” rule, and afterward the bureau will likely have jurisdiction over the largest nonbank lenders as well.
Regulators Should Prohibit Dealer Compensation Based on Interest Rates
The Consumer Financial Protection Bureau and the FTC should issue regulations that prohibit car dealers from receiving compensation or that prohibit financial institutions from providing compensation to car dealers or that prohibit both in which the compensation varies with the interest rate of the loan. Car dealers already receive compensation in many ways other than the discretion to add to the interest rate. For instance, when a manufacturer gives a below-market interest-rate incentive, the dealer is paid through a flat-fee structure. Most credit unions pay flat-fee compensation. Commercially reasonable methods of compensation without the incentive for the dealer to sell the most expensive loan possible are already being used.
The FTC Should Prohibit Dealers from Deciding If Conditions Are Met
To combat the problem of yo-yo scams, the FTC should prohibit the use of conditions in car financing agreements in which meeting the conditions is at the sole discretion of the dealer. If a car dealer decides to send a consumer home with the car before the financing is final, then the dealer should retain the risk of the financing transaction ultimately not being to the dealer’s liking. The dealer is in a far better position to assess the potential risk that there may be a problem with assigning the financing. As such, the dealer should be charged with deciding whether to allow the consumer to leave with the car once terms are agreed upon, rather than placing the onus on the consumer to determine the risk of having to return to sign another contract.
Mandatory Arbitration and Class Action Waivers Should Be Examined
The issue of mandatory, binding arbitration and class action waivers should also be resolved. Virtually all car financing contracts include mandatory arbitration clauses that prevent consumers from litigating in court and prohibit the consumer from participating in a class action suit. These clauses often prevent consumers from seeking redress and, since arbitration findings are not required to be made public, prevent other consumers from knowing about a dealer’s conduct.36
Attorneys who encounter a potential auto fraud case should understand that an auto finance transaction is complex and has many variables. To understand fully the state of the law and what precedents may be helpful, attorneys new to auto finance cases should connect with attorneys who regularly take these cases.37Seasoned attorneys also regularly look beyond the issue that brought the client to them in the first place. Often the potential client is unaware of other violations of law or other abuses. Many sources of information can be accessed during discovery, and an attorney taking an auto fraud case should take the time to learn what information to seek.
The purchase of a car being one of the largest decisions a consumer makes in a lifetime, there should be attorneys willing and able to help consumers who have been victims of interest rate markups, yo-yo scams, and other practices that can cost consumers thousands of dollars in damages.
Senior Vice President
3 As discussed below, car dealers may in most cases add to the interest rate on a car loan for compensation. Note also, in a yo-yo scam, the consumer leaves the dealership with the car and believes that the financing is final or close to final. The dealer then pulls the consumer back into the dealership (like a yo-yo on a string) and requires the consumer to sign a new contract, almost always with terms unfavorable to the borrower. Below is a fuller discussion of this problem.
5 Car manufacturers operate a captive finance arm, but the dealers themselves have no financial control over those finance companies.
6 Insurance and protection products vary widely and may include extended warranties, vehicle service contracts, credit insurance products, guaranteed asset protection insurance or waivers, paint protection, upholstery protection, wheel and tire protection, roadside assistance programs, security systems, window “etch” protection, rustproofing, undercoating, appearance packages, and environmental packages.
7 The finance manager may receive several offers from financial institutions to buy the contract but will not show all the offers to the consumer. While the decision about which offer to present may be based on factors such as speed of finalizing and whether the offer allows flexibility to include additional insurance or other add-on products, profit is a key driver. E.g., an advertisement from a lender stated that when a dealer used the lender’s system, “[t]he results are arranged in order of potential profit, thereby minimizing the time spent, and maximizing the profit made, on every … deal” (Westlake Financial Advertisement, Subprime Auto Finance News, March 20, 2012, at 20).
8 Davis & Frank, supra note 4, at 2.
10 Id. § 20-101.2(b).
11 See National Consumer Law Center, Case Index—Closed Cases (n.d.) (list of cases and supporting documents).
14 Id. at 3.
15 Id. at 2.
17 Consent Order at 6, In re Ally Financial Incorporated, No. 2013-CFPB-0010 (Consumer Financial Protection Bureau Dec. 20, 2013).
19 Id. at 9.
21 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 15 U.S.C. § 1639b.
22 For a full discussion of yield spread premiums and their impact on the mortgage market, see Loan Originator Compensation Requirements Under the Truth in Lending Act (Regulation Z), 78 Fed. Reg. 11280 (Feb. 15, 2013).
24 Davis, supra note 18, at 11 (“Over two-thirds of respondents (68.3%) were not aware that this practice exists …”).
25 National Automobile Dealers Association’s Comments on Federal Trade Commission’s Public Roundtables: Protecting Consumers in the Sale and Leasing of Motor Vehicles 9 (April 11, 2011) (“One of these benefits is the access that most dealers have to multiple finance sources from which the dealer can seek competitive and affordable financing for consumers. Dealers’ access to captive and independent finance companies, banks, and credit unions frequently results in dealers being able to offer more competitive credit terms to consumers than consumers can secure on their own.”).
27 Id. at 14 (for loans requiring a manual decision, 72 percent of credit decisions were made in 45 minutes or less).
28 Contract language in retail installment contracts is in my files.
31 See Peak v. Ted Russell Enterprises, 2000 Tenn. App. LEXIS 120, at 2* (Tenn. Ct. App. Feb. 28, 2000).
32 Deposition of Gary Rhodes at 143, Jones v. Deacon Jones Nissan Limited Liability Company, No. 11-CVS-519 (N.C. Super. Ct. Wilson Cnty. Oct. 4, 2011) (in my files).
36 For a discussion about the problems of mandatory arbitration, including the impact on car lending, see Public Justice, Public Justice Comments to Bureau of Consumer Financial Protection in Response to Request for Information for Study of Pre-Dispute Arbitration Agreements, Docket No. CFPB-2012-0017 (June 23, 2012).