They know most car buyers don't take time to research financing options so they are likely to pass hidden fees into the car loan without anyone making a fuss.
What most people don't realize is that dealers do not finance the car loans. They simply arrange financing using their relationships with banks, financing companies, and in some cases their manufacturer's captive finance company.
Since they're middlemen, they get a piece of the pie. Here's how dealers typically screw over car buyers:
This is the most common car financing scam and it works on the premise that most car shoppers focus only on the monthly payment instead of the actual price of the vehicle.
Dealers will increase the car payment by including (or packing) products and services that you didn't ask for into the loan, such as extended warranties and GAP insurance. A monthly increase of only $33 over a 60 month loan will cost you $2,000.
This is when the dealer arranges the financing, let's you take the car home, then calls you up several days later telling you the financing fell through and that you need to bring the car back.
When you're back at the dealership, they will pressure you into signing a loan with a higher interest rate, larger down payment, or both. Either way, you end up paying a lot more than you expected and the dealer makes a nice, fat profit.
There are times when financing legitimately falls through, but these are rare and no dealer should allow you to take a car home in the first place unless they are 100% sure you will be approved. If you have bad credit and this happens, you can rest assured it was a scam all along.
The way to prevent this is to arrange your own financing - don't just rely on the dealer, they're not looking after your best interests.
Some dealers rely on the fact that many car shoppers don't know their own credit score. If you go to a dealership without knowing this and you're going to rely on them to get you an auto loan, you're just dying to be ripped off.
All it takes is for the dealer to lie to you about your credit score. After they do a credit check, they don't have to reveal what your score is, they can just tell you that you won't qualify for competitive financing rates.
At this point, most car buyers are desperate and think they won't get financed. When the dealer presents a loan with a high interest rate, you're more likely to take it, not realizing that you just gave the dealer thousands of dollars in extra interest payments that weren't necessary.
When you apply for financing through a dealer, they shop your application to several lenders and get to see what rates you qualify for. This is called the "buy rate".
Let's say the best interest rate they can get you is 6% - they then go ahead and mark up that rate, usually up to 4% (some states have a limit of 2.5%). The 6% loan you qualified for will now be presented to you as a 8.5% or even a 10% loan if they're especially greedy.
The dealer will keep the additional markup as their profit. (They actually split a small portion of the profit with the finance company). This profit is called "finance reserve" or "dealer reserve".
You may be saying to yourself "well, 2.5% isn't that much". It seems small, but it adds up to a lot of profit when you take into account the life of your loan.
Look at this example:
If you took out a $20,000 car loan at 6% interest for 60 months, your monthly payment would be $386.66.
At 8.5% interest, your payment would go up to $410.33
Over the life of the loan, you would end up paying an additional $1,420 - that's the profit the dealer would make on your loan. When you figure the average dealer only makes about $600 to $800 profit on the price of a new car, financing is as important as negotiating TWO new cars.
This is why it pays to shop for financing before going to the dealer. The dealer should try to beat the best rate you got on your own - not offer you the loan that has the biggest profit potential for the dealership.
But it gets even worse - here are the other ways they can make money if you don't do your own research and comparison shop.
As if marking up the loan rate wasn't bad enough, some dealers will present you with loans that have the highest profit potential rather than loans that will give you the best interest rates.
For example, your application may be approved by several lenders but each will have a different interest rate.
Let's say the lowest rate you qualify for is 5%, but the lender requires the dealer to pay a large acquisition fee, or maybe they have a finance markup limit of only 1%.
Let's now assume there's another lender with a higher interest rate - say 6%. But this lender allows a 2% markup along with a lower acquisition fee for the dealer. Which one do you think the dealer is going to present to you?
Remember, the dealer is under no obligation to offer you the lowest rate. They just want to make as much money as they can - and the only way they can do this is if you don't shop around for financing before going to the dealer.
Some finance companies offer dealers prizes and incentives for driving business their way. If a finance manager can get a free vacation by getting you to sign a bad loan, they won't think twice about it.
Again, the only way to prevent this is to setup your own financing through a bank, credit union, or some other source BEFORE going to the dealer.
Loan packaging is not very common, but it is a potential profit center for the dealer if you're not prepared.
This is when they package two or more loans together in order to secure a loan for someone with bad credit. The person with bad credit would not ordinarily be able to get a loan on their own, but when their loan is packaged with people who have prime credit, the finance company approves them.
This is great for the person with bad credit, but if you're the other person on that loan, you'll be subsidizing them by paying a higher interest.
The moral of the story? It's simple, just make sure you get financing lined up before heading to the dealer. It's amazing how many car shoppers don't follow this simple rule which can save them thousands.