Here's Why The Dealer Doesn't Want You To Pay That Car Loan Off Right Away

When shopping for your next new or used car, it's wise to examine your financing options before you go to the dealership. Even if you don't plan on taking a loan for your purchase, knowing whether or not to leverage a loan could make the difference in scoring your deal.

Recently, I've been reading various scenarios on my social feeds about customers who were frustrated with the car buying experience, and who walked away from what may have been a good deal because they didn't like the terms of how the car would be paid for. Often these were cash buyers who didn't want to take a dealer loan, or folks who did the smart thing and had pre-approvals but felt the dealer was "forcing" them to take another route. There are many times when it's worth walking away from a deal, but a lot of consumers don't realize that they could have chosen another way and still ended up with both a good price and a favorable way to pay for the car.

Consumers need to understand how dealers make money, because knowing these pathways can give them insight on which to leverage for their own deal. 

Dealer income comes from three primary avenues: the vehicle, add-ons like accessories and warranties, and the loan. The first is the profit on the car itself. In the case of a new car, the dealer has their wholesale cost, often referred to as a "dealer invoice," and the retail cost is the MSRP (or "sticker price"). The gap between these two is not as wide as most consumers think, usually about 5%. Even on used cars, by the time the dealer factors in the reconditioning and overhead cost, they typically aren't making several thousands of dollars in margin between what they bought it for and what they sell it for. Savvy shoppers may score a deal on a car at, or even below, the dealer's "cost" for a new or used model.

Therefore, most dealers rely on the "back office" or finance to make a chunk of their profit. Dealers are happy to sell you extended warranties and service plans that, more often than not, don't give the consumer a great value considering their cost. There are exceptions to this rule but, statistically, most buyers don't get the full monetary benefit from these plans.

Then there is the profit that happens when you get a loan. In this arena a dealer can profit from the interest rate: this practice is known as "dealer reserve." If a dealer says they have you "approved" at a 7% APR, but they really have you approved at 5%, you take that 7% loan and they get to pocket the 2% difference. This is why it is critical to get pre-approvals from other lenders before you shop for your next car, especially if your credit score is below 700, as the "reserve" tactic is commonly targeted towards buyers who don't have great credit.

Even without the "reserve" profit from the finance office, the dealer gets a kickback from the bank for acting as an intermediary for that loan. This is perfectly fine, assuming you're getting a competitive rate. These "back end" profit streams are the crux as to why dealers don't usually prefer "cash" buyers because those additional income streams are closed. Sometimes, a lower price or a factory rebate will be contingent upon financing with the dealership.

It's at this point where a lot of "cash buyers" get frustrated, because they just want to write a check and pay for the car without the additional hassle. I will often recommend that the consumer take the loan to get the extra discounts, then simply pay it off immediately. 

Often, in the finance office, the manager will tell the customer that they need to make a certain number of payments–usually 3 months–before wiping the loan out. This is not legally binding at all, and the reason dealers tell people to wait is, if that loan is paid off too early, the bank will pull that "kickback" that the dealer got for signing you up.

This brings me to another avenue that most buyers don't know about: auto loan refinancing. Unlike refinancing a mortgage, which can be costly and very time-consuming, refinancing an auto loan is relatively easy and usually does not have any additional costs. If you don't have the luxury of paying cash for a car, but do have a pre-approval through a local bank or credit union at a more competitive rate than what the dealer will offer, often these lenders will refinance car loans at a similar rate.

When shopping for pre-approvals also inquire about the possibility of refinancing loans as well. This can allow you to take the dealer's offer with whatever caveats are necessary to get the most competitive price, then have your other lender take over the loan with you benefiting from the lower rate.

The better dealerships out there likely won't care if you are paying with cash, using your own lender, or taking their financing. Still, if you do plan on doing an immediate payoff, or a loan refinance, I would advise buyers to keep those cards in their pocket when discussing terms with the dealership.