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When dealers provide truck or equipment financing, “rate spread” refers to the difference between the “buy rate” and the “sell rate” (also known as the “contract rate” or “dealer reserve”). This spread is a primary way that dealerships generate profit from arranging financing for their customers.
The fact that dealers can make money from arranging your loan is not automatically negative or a rip off. They are providing a service of assisting the buyer obtain the money to invest in their business. This is no different than ‘Loan Brokers’ for home mortgages or other services. If you are unable to secure the financiering you need to purchase your truck or trailer – and the dealer has contacts where they can help, what is wrong with compensating them for helping you in your business??
The take away from this information is for you to know the dealer may – but not always – be making additional money from the transaction beyond just selling the equipment. Knowledge will help you work out a deal that is fair to everyone involved – you, the dealer and the finance company. If you seriously have objections to the dealer earning money for helping you get the money you need – maybe you should arrange all your financial needs before you even start shopping.
Here’s a detailed summary:
1. The “Buy Rate”
- Definition: This is the wholesale interest rate that the financial institution (bank, credit union, or captive lender) quotes to the dealer for a customer’s loan. It’s the minimum rate the lender is willing to accept based on the customer’s creditworthiness, loan term, and other factors.
- Factors influencing the buy rate:
- Customer’s credit score: Higher credit scores typically lead to lower buy rates.
- Loan term: Shorter terms often have slightly lower rates than longer terms.
- Loan amount: Larger loan amounts might sometimes qualify for slightly better rates.
- Lender’s policies: Each lender has its own risk assessment and pricing models.
- Market conditions: Overall interest rates in the economy affect the base rates.
2. The “Sell Rate” (or “Contract Rate”)
- Definition: This is the retail interest rate that the dealer actually offers to the customer.
- Dealer Markup: The dealer adds a markup to the buy rate to arrive at the sell rate. This markup is the “rate spread.”
- For example, if the bank offers a buy rate of 5%, the dealer might offer the customer a sell rate of 6% or 7%. The 1% or 2% difference is the rate spread.
- This markup can be a significant source of profit for the dealership, potentially adding hundreds or even thousands of dollars over the life of the loan.
3. How Dealers Profit from Rate Spread
- Dealer Reserve/Finance Reserve: The markup the dealer adds is often called “dealer reserve” or “finance reserve.” This is essentially a commission the dealer earns for originating the loan.
- Payment from Lender: Lenders typically share a portion of the interest generated by the marked-up loan with the dealer. This can be a flat fee or a percentage of the loan amount, or it can be realized over the life of the loan. Many dealerships prefer to take a smaller amount upfront.
- Incentives: Sometimes, manufacturers or captive lenders (e.g., Toyota Financial Services, Ford Motor Credit) offer special low-interest rates (like 0% APR). In these cases, dealerships usually earn a flat fee from the manufacturer for arranging the financing, as there’s no interest rate to mark up.
4. Why Rate Spread Exists and What it Means for Consumers
- Compensation for Services: Dealers act as intermediaries, connecting customers with various lenders and handling the paperwork. The rate spread compensates them for this service.
- Negotiability: The rate spread is often negotiable. Consumers who are aware of this can try to negotiate a lower interest rate, especially if they have pre-approved financing from their own bank or credit union. Having a pre-approval provides a benchmark for comparison.
- Lack of Disclosure: Dealers are generally not required to disclose the buy rate or the amount of their markup. This can make it difficult for consumers to know how much they are truly paying in dealer profit.
- Impact on Loan Cost: A higher rate spread directly translates to higher monthly payments and a greater total cost of the loan for the consumer over the financing term.
5. Regulations and Best Practices
- While marking up interest rates is generally not illegal, consumer protection laws aim to prevent unfair or deceptive practices.
- Some regulations, like the Home Mortgage Disclosure Act (HMDA), require reporting on rate spread for certain mortgage loans to identify potential discriminatory lending practices. However, these specific regulations often apply more directly to mortgages than to auto or equipment financing in the same way.
- Best Practice for Consumers: To get the best deal, it is highly recommended that consumers:
- Shop for financing independently: Get pre-approved loan offers from banks, credit unions, and online lenders before going to the dealership.
- Compare offers: Use these pre-approvals to negotiate with the dealership. If the dealership can beat or match your outside offer, it might be a good deal.
- Focus on the “out-the-door” price: Consider the total cost of the vehicle, including the purchase price, interest rate, fees, and any add-ons, rather than just the monthly payment.
In essence, rate spread is a common profit mechanism for dealers in vehicle and equipment financing, but it’s crucial for consumers to be aware of it and to leverage competition to secure the most favorable financing terms.
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