BMO Harris shaking up rules of game for car loans

One of the largest banks in the metro area is believed the first to change the way it rewards auto dealers for originating car loans on the bank’s behalf.

Perhaps more interesting is that BMO Harris Bank’s dealer compensation change—to a flat-fee based on a vehicle’s purchase price—brings to light how consumers have for years unknowingly footed a payment to dealers through higher interest rates on their car loans.

Traditionally, banks have given dealers discretion to tack on slightly more interest on a car loan, known as dealer reserve or dealer markup. The bank eventually cuts the dealer a check for its share of the additional interest rate collected through the dealer interest-rate markup.

The practice has come under scrutiny following legal actions by the federal Consumer Financial Protection Board. The agency alleges some lenders have abused this discretion, to mark up rates disproportionately higher on loans to minority borrowers.

Late last year, Ally Financial shelled out nearly $100 million to the federal government to put to rest CFPB allegations of discriminatory pricing in the dealer reserve.

CFPB Director Richard Cordray last month applauded BMO’s change in compensation to dealers, calling it “a proactive step to protect consumers from discrimination.”

Rather than giving dealers the discretion to charge up to a set amount in additional interest on a car loan, BMO now pays a flat fee of 3 percent of the amount financed, on loans of three years or longer.

Many dealers “have told us that they appreciate that this change has created a simpler and more transparent financing process,” said BMO spokesman Patrick O’Herily.

Whether other lenders will follow BMO’s approach is yet to be seen. The bank is taking a risk that dealer finance managers might stop originating loans on BMO’s behalf if they can get a bigger cut through the traditional dealer-markup approach.

For example, a 3-percent flat fee on a $20,000 car would amount to $600—while a 2-percent interest rate markup could net a dealer about $1,200 on a longer-term loan.

“I do not believe other [lenders], especially the large ones, are likely to follow this move,” said Christopher Willis, an attorney at Atlanta law firm Ballard Spahr LLP who has represented a number of financial services firms facing government investigations by agencies such as the CFPB.

“There is a very significant competitive disadvantage associated with switching a dealer’s compensation model.”

He also said BMO Harris is not one of the larger participants in this lending realm and thus, “I don’t believe its decision will induce the larger players to alter their dealer compensation models at this time.”

But lenders clearly are feeling the heat from regulators, namely the CFPB and the U.S. Justice Department, said Chris Kukla, vice president of the Durham, N.C.-based Center for Responsible Lending.

“We know they are in discussions with other lenders,” he said.

‘Virtually invisible practice’

In an attempt to diffuse potential regulatory intervention, earlier this year the National Automobile Dealers Association backed a plan to let each dealer set a percentage ceiling for its markup.

At least this way, dealers could make changes “without just completely turning the process upside down,” said Marty Murphy, executive vice 

president of the Automobile Dealers Association of Indiana Inc.

Besides, Murphy said, dealers have every right to be compensated for arranging financing for consumers because they often can find consumers the best underlying interest rate. “The dealer is sometimes getting better rates for you because they’re referring the business.”

Moreover, they’re able to secure loans for borrowers with spotty credit because they deal with multiple lenders daily and know which are more willing to bear a little extra risk on behalf of the credit-challenged consumer, Murphy added.

It is indeed true that many consumers with blemished credit prefer to go through dealers to find them financing, Kukla acknowledged.

But he insisted there’s nothing stopping a consumer from shopping for the best rates and terms on his own, before walking into the showroom.

Kukla said the dealer interest-rate markup is a “virtually invisible practice” that adds billions of dollars to the cost of car loans. The center estimates that, for dealer-financed car loans bought in 2009, over the life of the loans consumers will pay $25.8 billion in interest for the markup alone. The average markup is 2.5 percent, amounting to hundreds of extra dollars per loan, the group claims.

“As far as the consumer is concerned, the consumer knows none of this” occurs, Kukla said. “They don’t know that the dealer has added percentage points to the loan.”

It’s why, he said, a salesman will take a credit application and rush it down to the finance manager and then talk up the consumer for several minutes. That gives the finance manager more time to communicate—usually through a Web portal—with lenders willing to buy the loan at terms favorable to the consumer and to the dealer.

Those lenders often bid a “buy rate,” or a minimum rate at which the lender will finance the loan—plus an additional ceiling up to which a dealer can tack on more interest at his discretion.

This dealer markup might be, say, an extra 1 percent or 2 percent in interest.

It reminds Kukla of a practice used in mortgage lending, where a mortgage broker takes a cut of the interest rate for bringing a loan to a lender.

“We have long advocated for a compensation system that is divorced from the interest rate,” he said.

Flat fee better deal?

While BMO’s flat-fee approach is more transparent, it’s not clear to what extent borrowers might wind up footing the bill for the markup, as they already do today.

In other words, might BMO now simply raise its underlying buy rate on the loan, rather than the dealer?

BMO’s O’Herily replied: “One of the goals of our change was to increase transparency for our customers. We believe the increased transparency will have a positive impact on our customers.

“The rates we set are competitive in the marketplace, and we constantly evaluate them.”

ADAI’s Murphy reckoned the expense for the dealer fee will be passed on to the consumer, “but I am not certain if that is done as a higher rate or with additional fees.”

The other question is, assuming consumers still foot the bill for the dealer reserve in some way under the new flat-fee system, will it be less money than under the traditional approach of tacking on a percentage point or two to the car loan? In some cases, yes.

As for the effect on BMO, the bank said it’s not concerned about losing dealers because of the new compensation system, which was effective April 24.

“We know our dealer customers very well. We’ve always prided ourselves on the high level of service we provide to our dealer customers, and we’ve spent a lot of time helping them understand and manage this change,” O’Herily said. “The feedback so far has been positive.”

Dealers contacted by IBJ did not return phone messages.•