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Most of us think we know how auto loans work. As with most loans, the interest rate we pay is based primarily on our credit scores, with lenders also looking at our debt-to-income ratio, employment, and other factors. If we’re financially stable we get the best interest rates.

Many of us have seen charts like this one:

Credit score categoryAverage loan APR for new carAverage loan APR for used car
Deep Subprime (300 to 500)14.59%20.58%
Subprime (501 to 600)11.03%17.11%
Non-prime (601 to 660)6.61%10.49%
Prime (661 to 780)3.48%5.49%
Super Prime (781 to 850)2.34%3.66%

Source: Business Insider

That seems very neat and very predictable: the higher your credit score, the lower your interest rate. What we forget is that those are averages, and in the real world there’s no assurance that we’ll be offered the right rate for our score.

Most of us don’t think about the great auto loan scam. Many of us don’t know it exists.

Car dealers and lenders have taken billions from consumers, even as we assumed that we were offered the best rates available for our credit score range. How did they do it? Let’s take a closer look.

Anatomy of a Scam

In October 2021 Consumer Reports released a study based on an analysis of nearly 858,000 auto loans. What they found was that consumers with virtually identical financial records were charged wildly different interest rates. Even customers with good credit could end up paying extremely high rates.

Borrowers with credit scores of 660 and higher had average APRs ranging from 3.73 to 5.94 percent. But nearly 21,000 consumers in those credit tiers—about 3 percent of the entire group—paid exorbitant rates of 10 percent on up to more than 25 percent.

The study found that even consumers with excellent credit could be given subprime loans carrying astronomical interest rates.

How does this happen? The conclusion of the study was that in many cases lenders don’t base interest rates on your credit score or financial capacity. They simply charge what they think they can get away with.

The financing you get has a lot more to do with how prepared you are for battle when you walk onto the showroom floor than your financial history.

R.J. Cross, US Public Interest Research Group, via Consumer Reports

The Culprit: Dealer Markups

Experian reports that 61% of new car buyers finance their purchases through a dealer. Dealer financing is simple and you can combine the financing and the car purchase in a single shop. 

Dealers that offer financing don’t lend money themselves. They source loans from independent lenders, often conducting multiple applications to find the cheapest loan. The problem is that the dealers don’t have to pass those savings on to the customer. They can mark up the interest rate and keep the difference as part of their profit margin. Dealers are not required to disclose these markups.

That puts dealers in a position to leverage several key advantages.

  • Lack of preparation. Many customers walk into a dealership without getting pre-approved for a loan or doing research into car loan rates.
  • Lack of knowledge. Many car buyers don’t know that they can and should shop around for the best loan rates.
  • Excitement. New cars are excisiting, especially when a professional salesperson is offering a nice car with what seems like an affordable monthly payment.
  • Experience. Car salespeople have dealt with hundreds or thousands of customers and they can spot an easy mark in seconds.

Not every dealer is going to rip customers off. Some will offer the best rate they can. Others will look for a low rate and mark it up to the average to pad their bottom line a little. Others will add as much as they think the customer is willing to pay. Because they get away with it, the incentive to exploit those markups is enormous.

Lax Underwriting Standards

Underwriting is the process that lenders use to evaluate the risk of lending to you. Checking your credit is one part of the underwriting process. If underwriting standards are good, there should be very few delinquencies or defaults.

Consumer Reports found that many auto lenders used relatively poor underwriting standards. Only 4% of borrowers had their income checked, and even fewer went through employment verification. As a result, many borrowers were given loans that they couldn’t afford to pay, often paying well above the recommended maximum of 10% of their income.

As a result, delinquencies and repossession were relatively common. 5% of all loans were delinquent, and up to 12% of nonprime and below loans end in repossession.

Dealers can afford to take a lax view of risk because repossession has gotten much easier. GPS trackers and remote engine shutoff devices allow a dealer to locate and disable a vehicle easily. The high profits made on loans at or below the non-prime level make them worth the risk.

For a borrower, repossession can be a major problem. A repossession causes significant damage to the borrower’s credit. If the borrower owes more than the car is worth, which is common with long-term loans, they may be liable for the difference. Without a vehicle, many are unable to get to work.

👉 The bottom line: a borrower cannot assume that the lender will only lend what they can afford to pay. Borrowers need to protect themselves.

Racial Discrimination in Auto Lending

Research has confirmed that racial bias exists in auto lending. A 2019 study by faculty members of the Jones School of Business at Rice University and the Cox School of Business at Southern Methodist University confirmed that borrowers belonging to racial minority groups were less likely to be approved for loans and paid higher interest rates than white borrowers with the same qualifications. The disparity was highest in states with a high prevalence of racial animosity.

The same study found that minority borrowers had lower default rates than their white counterparts. 

A 2018 study by the National Fair Housing Alliance reached similar conclusions.

  • Non-White testers were given more expensive options than White testers 62.5% of the time.
  • The average total cost difference in those cases was $2,662.56 over the life of the loan.
  • White testers were offered more financing options than Non-White testers in 75% of cases.
  • Dealers were more likely to offer incentives, rebates, and help with getting lower loan rates to White testers.

The study noted that similar audits in the more heavily regulated mortgage industry found much lower levels of discrimination.

Racial discrimination is closely linked to dealer interest rate markups. Other studies have found that dealers are more likely to mark up interest rates for minority borrowers. Because race is not indicated in credit scores or reports, the actual lenders have no way to determine a borrower’s race. The dealers, who have face-to-face contact with the buyers, are the obvious source of discriminatory decisions.

In 2013 the Consumer Financial Protection Bureau initiated an enforcement policy that reduced the racial disparity in interest rates by 60%. This program was stopped in 2018.

How to Protect Yourself from the Auto Loan Scam

Consumer advocates have proposed laws that would prevent dealer markups on auto loan interest rates. Those laws would go a long way toward eliminating the great auto loan scam. Those laws have not passed yet, and may not pass any time soon. Until they do, consumers have to protect themselves.

Prepare

If you’re thinking of buying a car, don’t start by visiting a dealer. Look closely at your budget and decide what you can pay. Assess your needs and decide what kind of vehicle you want. Do some research into models and prices and decide whether you want a new or used car.

Dealers can be extremely persuasive and it’s easy to get carried away and buy more car than you need. Knowing what you want and what you can afford to spend will help you stay grounded.

Pre-Qualify

Many lenders will pre-qualify you for a car loan with only a soft credit check that has no impact on your credit score. A pre-qualification does not commit the lender to the terms they offer, but it’s a great way to determine what you can afford to spend and which lender will give you the best terms.

Before you visit a dealer, try to pre-qualify with several lenders, including prominent online lenders and your own bank or credit union. Online loan brokers can get you several offers from a single application and are an easy way to compare.

Read each offer in full and ask for clarification if there’s anything you don’t understand. Choose the best offer you receive and bring it with you when you shop.

Stay Smart

Dealers will use every trick in the book to get the most favorable deal for them, and you should do the same. When you visit a dealer, don’t tell them right away that you have pre-qualified for a loan. Keep that to yourself. 

If a dealer thinks they are going to sell you a financing package, they may offer you an attractive price, expecting to get the money back by marking up the financing quote. Ask for a firm price offer in writing before you discuss financing. Stick to your target price and don’t let the dealer sell you on a more expensive model or expensive options that you don’t need.

Compare Offers

Once the dealer has given you a firm price, show your pre-qualified offer and ask the dealer if they can beat it. When the dealer makes a financing offer, compare it point by point with your pre-qualified offer.

Don’t let the dealer talk you into a “deal” with a lower monthly payment or a more expensive car for the same monthly payment. Dealers do this by selling you a longer-term car loan, and these loans come with a whole host of problems. If you can’t afford the monthly payments on a 5-year loan, consider a cheaper car or a used car.

Always compare the total cost of the loan, not just the monthly payment.

💡 If you have to take on a car loan and your credit isn’t great, you may want to refinance when your credit is better. Check your loan offers for prepayment penalties that could make refinancing difficult.

The dealer may offer a better deal than the pre-qualified offer. If they do, take it. If not, you have an option to fall back on.

Shopping for the best loan offer is the most effective way to get the best deal. It’s also the most effective way to protect yourself from car loan scams driven by dealer interest rate markups.

Yes, It’s a Scam… But You Can Protect Yourself

Some dealers defend interest rate markups as a normal part of the business. They’re entitled to their opinions. When we see two people with identical qualifications paying wildly different interest rates, we call that suspicious. If we see borrowers with prime credit scores paying sub-prime interests rates, we call that a scam. When we see minority borrowers paying higher rates despite having lower default rates, we call that discrimination, because it is.

Should government regulators crack down on these practices? Yes, they should. Borrowers should have the right to expect that they will be offered rates and terms consistent with their credit scores and overall risk profile. 

We all understand that people who pose more risk pay higher interest rates. That’s not always fun, but it’s fair. Paying more because the dealer thinks they can work you or doesn’t like the color of your skin is not fair. It’s a scam.

Don’t Be a Victim

Until regulators step up and do their jobs, it’s up to buyers to make sure they aren’t easy marks for this scam. Here’s how.

  • Know what’s going on. Understand the practice of dealer markups and what it lets dealers get away with.
  • Get informed. Before you shop, check your credit score. Find out what the average interest rate for people with your score. If a dealer offers more, ask why.
  • Get pre-qualified. Comparing multiple pre-qualification offers and having an option is the best protection against dealer manipulation.
  • Stick to your guns. Car salespeople are pros, but you can stand up for yourself. Stick to your maximum price and force the dealer to beat your pre-qualified offer. Don’t let the dealer sell you a long-term loan.

Even a dishonest car dealer won’t scam everyone. Like all predators, they look for an easy target. Don’t be that easy target, and the chances are the dealer will make their move on someone else.

Consumers shouldn’t have to protect themselves. If lenders were barred from marking up interest rates or at least required to disclose rate markups, car lending would be a lot fairer. Until that happens, the best protections are knowledge and vigilance.