Hidden costs in auto loans and discrimination
There’s a round-the-clock debate among macroeconomists about how high interest rates need to go to cool off demand and bring inflation down. Rising delinquencies in loans, including auto loans, is seen as a sign that consumers are starting to buckle.
The aggregate trends are important, but it’s worth remembering that people don’t face one price. My Bloomberg Opinion piece last week gives one example: how lurking below the surface of auto loans is discrimination against Black borrowers.
Today’s post provides some highlights from my piece.
Why is the market for auto loans especially problematic?
For many car buyers, the process has three steps: 1) decide on the car 2) negotiate its price, and 3) get an auto loan. With multiple car dealers and online information about the value of the cars, the first two steps are relatively transparent and competitive. But when the dealer helps the buyer find a lender, there’s a little known feature of loans—the dealer markup—that has made buyers vulnerable to discrimination.
After a customer and dealer agree on a price, the dealer works with a lender to set financing terms. That lender, which could be a bank or the finance arm of the manufacturer, referred to as a captive lender, sets an interest rate. The dealer can add a markup on top of the interest rate the lender charges and does so with many of the loans. Customers only see the all-in rate, and most do not even know that the dealer adds a markup.
The fact that the markup is not disclosed to the borrower and the dealer has discretion over its amount is what sets up conditions which allow discrimination.
What is the evidence of discrimination?
And in fact, detailed information on loans shows that the average markup for Black borrowers is higher than that for White borrowers.1
A 2006 paper by Vanderbilt University professor Mark Cohen analyzed more than three million customer records from 1993 to 2004 from five captive lenders and found that the average markup was twice as large for Black borrowers as White borrowers, or $746 versus $349. Moreover, Black borrowers were more than 20 percentage points more likely to receive a markup. The disparities led to lawsuits against large auto lenders in the late 1990s and early 2000s under the Equal Credit Opportunity Act.
And those are just the averages. Black borrowers were over-represented among borrowers with the largest markups, being charged thousands of dollars on top of the lender’s risk-based interest rate.
Cohen argues there is no evidence that the size of the markup is related to anything but dealers making hidden profits. And that’s not a legal justification for charging Black borrowers more; such discrimination is illegal. In the lawsuits, the lenders either settled or lost their case, with some limits placed on markups. But differences in markups by race have persisted, according to a recent research by Jon Lanning. And as before, there appears to be no explanation other than the borrower is Black.
Addendum: Some commenters argued below that Black borrowers, on average, receive a higher markup due to other characteristics that are correlated with race.
Here is one example of the concern:
It’s possible and both of the two research studies I cited explore the ‘correlation’ hypothesis. Here’s Lanning’s summary: he finds no evidence that Black borrowers are less savvy (“canny”) in the the bargaining over the car price:
Black customers have similar negotiation skills compared with White customers by looking at the average price paid for each specific vehicle in my data set (the same make, model, model year, new or used status, etc.) in a given area (as there may be different market characteristics across geographies). I found that Black customers negotiate virtually identical prices as do White customers, which is consistent with Black and White customers having similar negotiation abilities. This indicates it is highly unlikely that there is a meaningful disparity in the ability to negotiate between Black and White customers that would be reflected in the interest rates on their respective auto loans (especially since very few customers of any race or ethnicity are aware that a markup exists, let alone that it may be negotiable).
Likewise, measures of creditworthiness (credit score, loan amount, and the risk-based interest rate) and financial literacy do not explain the differences in the markups by race. That does not rule out all possible information on an individual’s financial savvy, but those are the most accessible to dealers. Making a Black borrower with the same observable (non-demographic) characteristics as a White borrower pay a higher loan markup is discrimination and is generally, illegal in lending.
But that doesn’t tell us the source of the discrimination. One explanation—in the spirit of the commenter above—is that dealers believe that Black borrowers as a group are less savvy and would be more willing to pay a high markup. In this case, the dealer may be skeptical that good bargaining skills on car price are a reliable sign of the how savvy the Black borrower is, and so the dealer charges a higher markup. That’s referred to as “statistical discrimination.” Lanning does not find evidence for that explanation. (See his summary for his statistical tests.)
Instead, Lanning finds that local differences in prejudicial attitudes—as measured by a large, reputable survey—best explain the higher loan markups. This is referred to as “taste-based” discrimination. Note, none of these results suggest that all or even many dealers are prejudiced. These are average effects.
So, what would eliminate discrimination in markups?
Getting rid of markups.
The markups are a form of compensation for dealers for bringing business to the lender. That compensation is not a problem; it’s the fact that dealers have discretion and there’s evidence that it’s leading to discrimination. A better approach would be a fixed fee to dealers by the lender for all such loans.
But to work, it must be mandatory. The CFPB in 2013 suggested that dealers voluntarily end markups, but that’s unlikely. In 1992 Nissan’s captive lender said it would no longer pay markups to dealers, and would instead rely on fixed payments based on the loan characteristics. The result? Dealers went to other lenders that still had markups. Nissan reinstated markups. Voluntary is not the way to go.
In my Bloomberg Opinion piece I offer two other possible solutions to discriminatory. I also explain the importance of vehicles in the wealth of Black families. And more.
In closing
Hidden discretionary fees, like dealer markups on auto loans, put consumers at a disadvantage, especially ones subject to discrimination. Higher markups make buying car—which is a necessity for most people—more costly and raise the chance of default. And it’s one more example of the extra financial burden on Black families.
Credit records do not include race or Ethnicity and lenders cannot ask about it. So Cohen matched the credit records to drivers licenses and birth certificates, identifying race of individuals on about half the credit records.
The discrimination is self-reinforcing when higher interest rates lead to a higher rate of default.
A bad problem in the shadows. Some sunlight always has a good effect.