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Auto loan potholes

Summer is traditionally a busy time for car dealerships. Automakers have just showcased their newest models at auto shows across the country and dealers want to clear their lots to make room for the new models. Motivated by warming weather and advertised deals, consumers are primed to buy.

Car shoppers may find cash rebates and offers of zero-percent or low-interest-rate financing. But before you decide to buy and finance a new car or truck, there are a few rules of the road to be aware of.

Not all auto loan deals apply to you

The average rate on new and used auto loans currently hovers around seven or eight percent. No wonder zero-percent or low interest rate financing deals advertised by dealerships sound so tempting.

But potential buyers need to know that unless they have stellar credit (that is FICO scores above the low 700s), they may not qualify for these offers. As a matter of fact, 40 percent of people who recently went to a dealership to explore zero-percent financing had to pay a higher rate, according to Consumer Reports.

Dealer rate markups

When shopping for a car, most people decide to obtain a auto loan through the car dealership itself. It's certainly the most convenient option, and dealerships promise you the best available rate.

However, don't assume they are providing all the information you need to make an informed decision. Dealers simply offer to "arrange" financing for you -- they are not actually putting up the money themselves.

Once they obtain a auto loan commitment from the automaker's financing company, many dealerships mark up the loan by adding two to three percentage points to your rate.

For instance, let's say you qualify for a auto loan at a five-percent interest rate. The dealer may tell you that you actually qualified for an eight-percent rate.

You pay the eight percent and the dealer pockets the extra three percentage points in the form of a lump-sum payment from the finance company.

This is an accepted practice among dealers -- and it's legal. In fact, many "finance guys" at auto dealerships get paid commissions that are based on the amount of the interest-rate markups they can add to their customers' auto loan.

The Consumer Federation of America released a report in January 2004 revealing that this practice costs consumers up to $1 billion annually, adding at least $1,000 to the cost of an individual's auto loan.

Dealers justify this practice by saying that they should receive a fee for arranging financing and handling paperwork. But in many cases, these fees are several thousands of dollars. About one in every four consumers gets hit with a marked-up rate.

Consumers should also realize that the finance folks at the dealerships typically earn commission from any additional interest they tack onto a auto loan. In other words, their interests are in direct conflict with consumer interests.

While there are no laws regulating rate markups, auto companies and industry groups recognize this problem and are making some voluntary improvements.

General Motors declared in February 2004 that dealers must limit auto loan-rate markups to no more than 3 percentage points. Members of the National Automobile Dealers Association must now disclose to buyers that interest rates are negotiable.

Avoid loan stacking

Consumers need to know that there are several options to consider when financing a new auto purchase. No matter which option you choose to finance your car, be sure to avoid "loan stacking."

Many people will be trading in their current cars for a new car. If you are one of these people, chances are good that you still owe money on your current auto loan.

If your car's trade-in or resale value isn't enough to pay off the auto loan, you'll have to come up with the cash to pay off the loan. In these situations, car salesmen are trained in a technique they call "stacking loans." They offer a auto loan that pays off your old loan and finances your new car.

If you accept the offer, you'll owe more on your new car than it is actually worth -- you will essentially be taking out a auto loan for up to 120 percent of the new vehicle's purchase price. Unfortunately a growing number of consumers are in this position and need to know to avoid the situation.

Best idea?

What's the "best" auto financing option? While there is no one-size-fits-all piece of advice here, it is clear that consumers need to shop around; there are alternatives to auto dealer financing.

It's OK to get your financing through a dealership as long as you know what you're getting into. Studies show that consumers who are armed with their own research are much less likely to fall victim to excessive rate markups on dealer arranged auto loans.

The best strategy is to get pre-approved for a loan before you even step onto a car lot. That way you can negotiate the best price on a vehicle without getting tripped up over the financing.