Should You Finance Your Car With a Car Dealer or Bank?

As with most complicated issues, there’s no simple answer. The very fact that this question is complicated is exactly why you need to be very careful before you choose to finance the next car you purchase with the car dealer who sold it.

So, let me start by giving you a hard and fast rule. Never finance your car with the car dealer unless you have checked the interest rate and terms with at least two banks and/or credit unions. When you’ve completed the process of choosing the car you want to buy, the dealer who offers you the best price on that car, and the dealer who offers you the best price on your trade-in, you should be armed with quotes from at least two banks and/or credit unions on the lowest interest and best terms. Your own bank may even be the same bank that your dealer uses. If you have good credit, you can borrow the money directly from your bank for as little or even less than the rate the bank offers the car dealer. When you borrow money from the bank it’s called direct lending and when borrow through the dealer it’s called indirect lending. Just because the dealer says that he “does business” with your bank doesn’t mean that he’s giving you as good an interest rate that you can get from your bank; in fact, he’s probably not.

Did you know that the average car dealer makes more money on the car finance contract than he does on the sale of the car? A car dealer’s finance department is a separate profit center in a car dealership, just like the new car, used car, service, and parts departments. AutoNation, the largest retailer of cars in world, averages about $1,600 on finance contracts for every car they sell. This includes cars that they don’t finance because some buyers pay cash or finance through their banks or credit unions. If you factor those out, the average profit per car actually financed by the dealer can soar to well over $2,000 to $3,000 or higher. I’m often asked the question, “If I pay cash for my car can I get a better deal”? Counter intuitively, the answer is no! In fact, there’s a good chance you will end up paying more for your car if the dealer knows you’re a cash buyer because he knows he is forgoing his better opportunity to make money from that purchase.

The code word for interest rate profit for car dealers is “reserve”. Dealer reserve is what the banks kick back to the car dealer when they assign the finance contract that you sign to that bank. Dealers have reserve agreements with certain banks, including the manufacturers’ banking subsidiaries. Examples of manufacturer lenders are Honda Credit, Ally Bank (Chrysler and General Motors), and Toyota Financial Services. Manufacturer lenders are referred to as “captive lenders”.

The car dealer is, in effect, borrowing the money from his bank, marking up the interest rate as high as is allowed by the bank, usury laws, and you. The name for the markup is the “spread”. The dealer might be able to borrow money from a bank for 2.69% and the bank might allow him to mark it up to 4.69%, a “2 point spread”. Marking up 2.69% to 4.69% is a 75% markup above the dealer’s cost (dealer retention) from the bank. A customer with good credit, say a 740 Beacon score or better, could borrow the money directly from the bank at 2.69% if that customer knew to ask. A customer who doesn’t know, and assumes the dealer is trying to get him the lowest rate will pay the dealer an extra $1,004 profit if he finances $20,000 for 72 months. The dealer usually will sell various “products” which are added to the finance contract and included in the payments such as extended warranties, GAP, maintenance, road hazard insurance, emergency road assistance, etc. These products can add up to $1,000 or much more. With interest rates at historic lows, many people who haven’t financed a car in many years don’t know that, with good credit, interest rates on new car loans can go below 2%. If they financed their last car at 5% and are quoted 4.69% by the dealer, they might think that’s a very good rate when it’s really very high.

There are times when it definitely pays to finance with the dealer and the biggest one is when the dealer’s manufacturer captive lender offers special low interest rate incentives such as 0%. When you read an advertisement for 0% financing, be sure that the lender is the dealer’s manufacturer’s captive lender, like Honda Credit. If the dealer is offering 0% through a bank not affiliated with his manufacturer, it’s not a valid offer. The dealer is simply adding additional markup to the car he’s selling you so that he can “buy down” the real interest rate the bank is charging. When captive lenders offer 0%, be sure you ask if there is an alternative cash rebate. Typically the captive lender offers something like 0% financing for 60 months or a $1,000 cash rebate. You need to do the math to find out which is the better deal. This is calculated by knowing how much you can borrow the money for from your bank or credit union and how much you’re financing. Unfortunately it’s common for dealers to advertise the car price including the $1,000 rebate and also advertise 0% financing. In the fine print they say “no two offers can be combined”.

Today, the federal government is going after banks, including captive lenders, for discriminating against minorities by charging higher interest rate without regard to the customers’ credit scores. They should be going after the car dealers instead of the banks, since it’s the car dealers who raise the interest rates. But the car dealers are hiding behind a loophole which names the bank as the primary lender, even though the dealer decides the interest rate and signs the customer to the installment sales contract.  This is because the dealer immediately sells that contract to the bank. The federal government is saying that all customers with the same credit score should be offered the same interest rate. Since the dealer is the one who determines the interest rate, why isn’t he held responsible?