When we think about borrowing money, the first thing that comes to mind is how much: How much we need, how much it’ll cost, how much we’ll have to pay each month and how much time it’ll take to get out of debt.
Whether the money’s for a house, a car, college or for an unpaid credit card balance, these four financial variables—principal, interest rate, payment amount and term—are the fundamental building blocks for loans that are designed to be fully paid off by the time the last check is cashed. Typically, three of these four variables are used to calculate the fourth.
For example, suppose a borrower is approved for a $20,000 car loan. Also suppose that the lender wants that to be repaid in equal monthly installments over a period of four years, for which it charges a 5% annual rate of interest. The monthly payment amount calculates at just under $461 (lenders often use a present value calculator for this purpose).
Although the math is cut-and-dried, there is a fair amount of interplay among the four variables. For example, an increase in the interest rate will bump up the monthly payment amount, all other things held constant. But if the payment were to remain the same, that increased rate would either force a decrease in the loan amount (more interest charged on less dollars loaned) or cause the repayment duration to lengthen, provided, of course, the lender agrees to that.
The reciprocal relationship that exists among these four loan variables goes to the heart of a problem that Sen. Elizabeth Warren (D-Mass.) finds troubling.
The Issue… & How It Gets Complicated
The senator is worried about auto loans that are originated at car dealerships and the instances where the pricing for these are discriminatory against women and minorities, and those who lack the financial sophistication to know that they’re being unfairly treated. She wants these so-called indirect loans (indirect, because dealerships initiate the loans on behalf of the lenders with which they work) to be subject to the same oversight that governs consumer loans that are originated by regulated entities.
The stumbling block is the Dodd-Frank financial reform legislation that was signed into law soon after the economic collapse. Although it authorized the creation of the Consumer Financial Protection Bureau to safeguard consumers against unfair treatment in finance, the auto industry successfully lobbied for a carve-out of dealer-originated lending, even though the same loans often end up at institutions the bureau oversees.
The CFPB doesn’t have a lot of support in today’s Congress. It doesn’t have a lot of friends within the financial services industry, either. Certainly, not after the multimillion-dollar fines the agency has levied and the added regulatory constraints it has imposed. It’s also a safe bet the bureau has even fewer allies within the auto industry as it seeks authority over nonbank auto lenders, which are also exempt, and, potentially, the type of lending that Sen. Warren is challenging.
Consequently, it’s unlikely that the votes will be there to amend the law so all this falls under the bureau’s purview, as it should. But even if that were to come to pass, how would the CFPB prevent abuse in transactions where a single party controls all the financial variables—in this case, the price of the car and the terms of the financing?
You see, auto dealers don’t have to charge certain customers higher interest rates than others. All they need do is discount the cars a little less.
Go back to the original example. Suppose a customer agrees to pay that $461 per month for his or her new car. Is it a $20,000 car that’s being financed at a 5% rate of interest, or a $19,234 car that’s being financed at 7%? Both scenarios yield the same monthly payment.
Moreover, should the $766 price differential be disclosed? If so, isn’t that tantamount to a roundabout way of controlling sales prices, too? If authorized, would the CFPB’s examiners be directed to audit loan documents and price-check sales agreements, too?
Let’s get real.
As important as it is for the CFPB to gain regulatory control over these last protected pockets of consumer finance, it’ll be hard to protect consumers who choose to finance their auto purchases this way. More likely, the misconduct the bureau is attempting to safeguard against will end up being dealt with on an exception basis — when consumers complain they’ve been unfairly treated. The question is: How will they know?
Unfortunately, not without some effort.
Cars and loans have something in common: They’re both commodities. So it’ll be up to consumers to shop for prices and interest rates online or even face-to-face. The key is to insist on separating the two transactions — buying the car and financing the purchase. It’s the only way to test the relative values of the individual economics. And don’t forget to assess the financing offers on an Annual Percentage Rate basis. APRs mathematically combine interest rates and fees into a single metric that’s easy to compare.