How to avoid hidden traps in dealer-financed auto loans

Consumer Reports News: June 11, 2010 04:13 PM

As Congress debates whether dealer-assisted financing should be regulated by a new consumer financial protection agency, there’s still much you as a prospective car buyer can do to protect yourself against predatory dealer practices.

Rosemary Shahan, president of California-based Consumers for Auto Reliability and Safety (CARS), advocates avoiding dealer-arranged financing entirely. One downside of that approach, however, is that you likely couldn’t take advantage of manufacturer-subsidized financing, such as low- or zero-percent offers and special lease deals, which typically require dealer involvement. Dealers also may be able to get a better rate from a certain bank than you can because they do business with that bank all the time. Of course, if you're shopping many banks, you still may come up with something better.

Here are some dealer financing practices that can affect you, and recommended actions beyond simply avoiding dealer-assisted financing.

• Marking up the rate. The dealership marks up the interest rate that the lender itself is charging, increasing your monthly payment and the overall cost of your loan. This generally is not illegal, although the amount of the markup often is limited to 2.5 percent or less under the agreements between dealers and finance companies.

What to do. Check for new and used car rates. (Be sure to sort the results by the “Rate” column.) Also check directly with online lenders such as CapitalOne and E-Loan and with local banks and credit unions. You may not be eligible for the best advertised rate, so obtain pre-approval to determine the lowest rate you can get based on your credit record.

• Yo-yo financing. A dealership says you’re approved—or likely to be approved—for financing at a certain rate. You complete the paperwork and drive away. After a week or so, the dealer calls to say your financing was denied and that you must accept a higher rate, make a larger down-payment, find a co-signor, or return the vehicle. The dealer may even threaten you with repossession or arrest. If you return the vehicle, the dealer may insist on keeping your deposit and the value of any trade-in.

What to do. Don’t accept so-called spot delivery of the vehicle, even if it means waiting a few days for the car. Make sure the dealer shows you a loan authorization number or other proof that a loan actually has been approved. Read all the documents carefully before you sign, being especially vigilant for wording that says the sale, financing, or other aspects of the deal are subject to certain conditions, such as loan approval. Don’t sign anything that says  “Spot delivery agreement,” “Temporary conditional financing,” or that has other wording suggesting financing hasn’t been approved.

Falsified Credit Application. The dealer provides lenders with an inaccurate credit application, perhaps increasing your income, to make you eligible for a higher loan. This may be done without your knowledge.

What to do. Make sure the credit application is correct before signing. Ask the dealer for a copy of the completed credit application as proof of what you signed, in case the dealer submits something different to the finance company. Don’t simply accept the lender’s opinion that you can afford a loan. Instead, make sure the monthly payments fit into your budget.

• Overpriced insurance. The dealer urges you to buy credit or “gap” insurance. This coverage is intended to make your payments if you lose your job or are injured. It also covers you if the vehicle gets damaged, stolen or destroyed, and you owe more than it's worth (a situation known as "being upside down").  Such policies may be overpriced, providing extra profit for the dealer and lender.

What to do. If you’re interested in this coverage, get quotes from an independent lender when you obtain your loan preapproval. Reduce or even eliminate the amount of time you’re upside down by opting for a loan that’s no more than 48 months long. Wait to buy until you can afford a down-payment of at least 20 percent.

• Negative-equity financing. This often happens when the outstanding loan on your trade-in is higher than the used vehicle’s value. The dealer tells you that, in exchange for your trade-in, he’ll credit you for the entire amount you owe and actually pay off your loan. Then he quietly rolls the difference into the new car loan, leaving you effectively paying off two car loans – the new one and the remaining amount on the old one.

What to do. Pay off the old loan before you think about getting a new car. To determine how much you should pay, check out a Consumer Reports' new and used care price services or one of the free alternatives, such as or Kelley Blue Book. Along with new car prices, TrueCar provides actual local and national transaction prices on most models. Ask the dealer for copies of the finance agreement and any other documents to take home, where you can read them without feeling pressure. (Incidentally, it’s a myth that you have a right to cancel an auto contract in three days or any other time period.)

• Phony down payments. The dealer provides a cash incentive to use as your down payment and make you look more attractive to lenders, quietly rolling the amount into the cost of the car. Alternatively, the dealer may engage in so-called power booking, telling the finance company that you’re buying a car with more options than yours really has. The goal is to obtain a higher loan than a lender would be willing to make for your vehicle as it’s actually configured. You probably won’t even know the dealer has done this. But if you’ve done your homework you’ll see the results: An unreasonably high vehicle price.

What to do. Focus on the price, not the monthly payments. Don’t be distracted by offers of “free” items, such as security glass etching or service contracts.

If you’re victimized by dealer financing abuse, contact your state consumer protection agency, the Better Business Bureau, and the appropriate federal consumer agencies, such as the Federal Trade Commission. It also may be worth calling a consumer attorney.—Anthony Giorgianni

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