Report:  Car Dealers Don’t Rip Off Subprime Borrowers   

Great news for car shoppers with low credit scores and incomes. New research from Texas McCombs - the University of Texas at Austin McCombs School of Business - reveals that dealers aren't ripping off subprime borrowers as some may fear.  Instead of exploiting subprime customers, who account for 14 percent of auto loans, the research finds the opposite is true.

Samuel Kruger, associate professor of finance at Texas McCombs, headed up the new Texas McCombs research.  It found that despite the concerns of some policymakers, on average, dealers actually lose money on subprime loans, which have lower interest rates, lower rate markups, and higher financing costs than prime loans.  

Not only that, but Kruger also found that dealers don't inflate their prices to make up for the difference. Instead, Kruger's research discovered that dealers offer subprime buyers both larger financial subsidies and lower vehicle prices.

“We find evidence of markups on interest rates, but there’s no particular increase for the deepest subprime customers,” said Samual Kruger,  Associate Professor of Finance, Texas McCombs. “In fact, as you get deeper and deeper into subprime, the markup is less. The differential concern about the subprime population is somewhat overblown.”

The Research: Subsidies for Subprimes

With Mark Jansen of the University of Utah and Gonzalo Maturana of Emory University, Kruger looked at data on 243,032 loans made between January 2004 and July 2019 by a subprime auto lender that served 2,187 dealerships across 39 states.

Borrowers fit the subprime profile, with median credit scores of 529 and gross monthly incomes of $3,936. More than a third had experienced bankruptcy within seven years before the loan’s origination.

But dealers weren’t exploiting those customers, the researchers found. They marked up interest rates an average of 1.02 percentage points, compared with what a prime customer would receive. But the markups didn’t cover all their costs for making the loans.

That’s because dealers sold 99% of loans to third parties at a discount, an average of 4% less than the loan’s original principal. Subtracting their 1% markup on interest rates, dealers lost money on financing: an average of $301 on each loan.

Kruger says the study suggests the forces at play in the subprime auto market are different from those of the prime one. Dealers might have several reasons for offering relatively good deals to such buyers:

• Usury laws, intended to protect consumers by limiting the maximum interest rates lenders can charge.
• Preventing loan defaults. They rise as interest rates do, giving incentives not to gouge borrowers.
• The risk of prolonging negotiations and losing the sale.

Above all, even though they lose money on financing, dealers still make an overall profit on selling the cars.

The message to regulators, according to researchers, is that well-intended efforts to curb dealer-facilitated loans could end up hurting subprime borrowers rather than helping them.

“In most cases, subprime borrowers are getting subsidized financing from the car dealers, and the dealers may also give them easier access to credit,” Kruger said. “Crackdowns on financing from car dealers could be damaging for these customers.”

The Dealer Perspective

Car Pro Show host Jerry Reynolds, who often advises car shoppers with credit challenges, agrees with Kruger's assessment.  As a former car dealer himself, Reynolds says reputable dealers have a vested interest in treating all of their customers on the up and up - and that includes subprime car shoppers who need third-party loans.

"I can tell you from my experience as a dealer, we always saw people with credit issues as a customer for life," said Car Pro Show host Jerry Reynolds. "If they came to us not thinking they could get a new car, and we worked hard and got them their dream car, they’d come back time and time again.  I saw this happen many times.  The opposite could also be true-the dealers that took advantage of these people never saw them again."

Editor's Note:  Texas McCombs is a business school that is part of the University of Texas, and is named after successful car dealership owner, Red McCombs.

Portions of this article used with permission from the  University of Texas at Austin McCombs School of Business.

Photo Credit: SaiArLawKa2/Shutterstock.com.