Monday, 20 August 2007

UK Car Loan Tricks and Tips

I've just finished helping a family member buy a car here in Scotland. The experience has been uncannily similar to that which occurs in Canada, a disagreeable negotiating process in which one feels taken advantage of, no matter how much of a price reduction one manages to negotiate. The less one likes cars, the better one is likely to do in negotiations since the dealers prey on our emotions - liking a particular car - to extract the most from us. There are a couple of things that arose in the buying process which I found especially dangerous to the consumer and which may save others lots of money. In our case, buying a car of around £8000, it made a difference of £650 in financing costs.

Tip - Get Prepared before Going Shopping
Duh? Perhaps this is too obvious to say, but doing a few hours research before leaving the house will save you money, will give you a car that satisfies your needs and should make the whole business much less stressful. That means figuring out things like:
  • a target price to pay, both in total and on a monthly repayment schedule
  • current financing rates available in the market - consult websites like MoneySaving,
  • which cars fit into your price range, the comparative pros and cons of those cars - buy What Car? magazine.
It also means reading up on the car dealers' sales tactics and how to counter with some of your own - e.g. how to do the good guy/bad guy routine to the dealer. Doing this stuff can actually start to turn the whole anxiety-ridden negotiation process into a kind of fun game, once you begin to feel on even terms with the dealer. Check out Car Buying Guide for some advice in that regard.

The above websites have a lot more detail and cover other important car-buying topics that really helped us.

Trick - Beware of Flat Rate Interest Calculations
Caution!! When we asked for financing rates at the dealer, the salesman initially offered us 6.0%. This sounded quite good, especially since bank loan rates currently start around 6.3%. This happened at all of the dealers we visited. One offered 5.25% and that sounded wonderful ... until we came home, did a little research at the above websites and discovered that UK car dealers will quote a so-called ''Flat'' interest rate on the loan that sounds reasonable but is actually about half the rate really being charged. In fact, car dealers are obliged by law, as regulated by the Financial Services Authority to tell the car buyer the real interest rate being charged, called the Annual Percentage Rate (APR). If we had gone through with a loan from the dealer we would have found out the APR but during discussions with the salesman, he was unwilling to tell us the APR. Note that APR is simply a normal amortized loan formula, whereby the interest is charged only on the declining principal balance as each month's payments reduces the principal over the term of the loan. APR is the only way to properly compare the cost of loans of differing terms and amounts. The same Flat Rate, on the other hand, will have a slightly different APR depending on the term or the amount (see my little comparison table image for an illustration of this).

This page of the Car Buying Guide shows step by step how the Flat Rate is calculated. It turns out that the Flat Rate charges interest on the total initial amount of the loan for every month of the term. If you borrow £8000 at 5% for 3 years then you get charged interest of 0.05 x £8000 = £300 / 12 months = £25/mo. each and every month for 3 years. A good graphical illustration and explanation of what is happening can be found here at What an unfair and deceptive way to charge interest!

Car dealers live in the real world too and they make more or less money on the basis of APR - more if the APR on the loan to the buyer is higher, less if it is lower. But their financing profit on a loan that is close to double the going best loan rates is perhaps more than the profit on the mark up of the car itself. So maybe they don't care about the fact that they make a slightly lower rate of profit (as measured by APR) on a five-year loan than on a three year loan.

Maybe they don't care but I think the real reason is that few car dealer sales people probably realize what they are doing and how the rates work out. Apart from the devious way it presents a seemingly lower rate of interest, the main characteristic of the Flat Rate method is its simplicity in terms of doing the calculation. No more than a calculator with big buttons and arithmetic functions is required, a definite plus when it comes to training sales people who may not even have finished secondary school (at one dealer we visited, the trainee salesman was a bricklayer who had decided to change occupations). By contrast the proper APR method requires calculating discounted cash flow (see the Wikipedia entry for the amortization calculator ). Ask yourself whether the average car sales person you have encountered could work out an APR payment. In fact, even the Flat Rate method seems to challenge some car dealership personnel as we were told by one sales manager a monthly payment amount for a supposed 5.75% Flat Rate that came out at 19.5% APR, which is not possible if done right. By the way, this reinforces the advice on those car advice websites cited above that one should always check the dealer's calculations for errors. Probably the sharp car dealership owner who invented the Flat Rate method realized that the combination of calculation simplicity and subtle consumer deception makes for a really useful sales tool.

In retrospect, we should have been suspicious of being offered financing on the spot without any credit check whatsoever by the dealer. The high Flat Rates likely more than offset the dealers' costs of bad loans to poor credit risks and give them the leeway to use this sales tool willy-nilly.

Tip - The Bank Won't Give You Its Best Deal Unless You Ask
Once we had figured out what was going with Flat Rate financing and that the rates at dealers were much too high, we visited our local bank branch of a major UK bank, where the car-buying family member has had an account for years. In other words, she has been a loyal customer with a stable job and a high credit rating.

So what was the initial offer - this time quoted in APR terms, hooray! - from the bank when we enquired? Answer: a measly 9.9%! Then we asked why we should not borrow from one of the on-line offers of other major banks on the MoneySupermarket website, whose range started at 6.3% and where the majority seemed to be around 6.9%. We left the bank and the manager promised to ''see what he could do''. Within a few hours he called back saying that lo and behold, the bank would now match the 6.9% rate because she was such a good customer and such a good credit risk. As they say, ''get me a bucket, I'm gonna be sick''.

After declining the bank's solicitation to also take out repayment insurance in case of accident or job loss - i.e. to pay more so that the bank could be sure of receiving the money, it was a done deal. The attached chart shows the net saving of £652 in total interest costs during the 3.5 year term of the loan over the dealer's initial financing offer, £470 over the bank initial offer and £442 over the dealer's best offer. That's a lot more than the £250 we managed to obtain as a reduction on the actual price of the car.

Bottom line, it's worth spending considerable effort on financing when buying a car.

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