What is interest padding?
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UPDATED: Dec 10, 2012
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Interest padding is the act of unethically increasing the interest rate on auto loans beyond what the borrower is really qualified for. Lenders “pad” interest rates because a higher interest rate leads to more money owed to them.
In all forms of financing, higher interest rates mean more profit for lenders. For example, an auto loan for $35,000 with 6 percent interest will certainly be more profitable for a lender than one of the same amount but with 4 percent interest.
Interest padding can be found in most every form of financing but is especially prevalent in vehicle financing.
In the auto industry, car dealerships purchase their inventory at a price called the invoice price. The invoice price is not the suggested retail price that manufacturers wish for dealers to offer customers, but instead it’s essentially the wholesale price. Rather, the MSRP (or manufacturer’s suggested retail price) is the price that manufacturers recommend dealerships sell their product.
Before MSRPs were required by law, dealerships could arbitrarily markup car prices based on what each salesperson thought a buyer “could” pay. With MSRP stickers on each vehicle though, this has become much more difficult. As a result, dealers turn to interest padding, in which they make money off of car buyers that need financing.
Dealers need to make money off of auto loans since most buyers will haggle to get a price near the MSRP sticker’s price. Luckily for dealers, few people purchase cars entirely with cash. Since most people need auto loans in order to purchase and pay off a car, dealers can use this opportunity to increase their profits by offering higher interest rates. This is made easier by the fact that most dealerships have their own in-house financing department that is ready to lend money to uninformed car buyers.
During the financing negotiation process, lenders can “pad” interest rates for any number of reasons. Those reasons all fall under a broad category called “risk.”
Let us imagine a buyer with a mediocre credit score who would have qualified for an interest rate of 4.99 percent if he got pre-approved for financing. Unfortunately, this buyer skipped that step and simply started car shopping at a dealership before doing any research. After looking at and test driving cars, he agreed to purchase one. The buyer signed an agreement borrowing an auto loan with 6.99 percent interest. The borrower will likely lose money over the long run now, even if the dealer reduced the sticker price of the car, since the higher interest would likely make up for any price reduction. His interest rate got padded.
Prospective car buyers and borrowers should shop around in order to avoid falling victim to any “padded” interest rates. Comparison shopping will allow borrowers to see which lenders and dealerships will offer them the best deal with the lowest interest rate. Before stepping foot on a dealership, buyers should look into their credit score or even do further investigation through use of a lease calculator.
Buyers can also avoid “padded” interest rates by getting pre-approved for an auto loan. Borrowers with pre-approved financing won’t even need to visit the financing office of a dealership before driving off the lot with their brand new car.