What it means
When you buy a car and sign finance papers at the showroom, you have probably taken an indirect loan. The dealer collects your details, sends them to several lenders, and presents you with an offer, and the chosen lender pays the dealer and takes over the loan.
For the dealer, this is convenient because it helps close the sale and can earn extra income. For the lender, it is a low-cost way to find borrowers, since the dealer does much of the selling and paperwork.
The dealer is often allowed to charge a rate above the lender's minimum approved rate, known as the buy rate. The extra, called the dealer reserve or participation, is shared between the dealer and the lender, and it compensates the dealer for arranging the credit.
Because the borrower never sees the buy rate, it pays to compare the dealer's offer with a loan arranged directly with a bank or credit union before signing. A direct loan, by contrast, is one where the borrower applies straight to the lender with no intermediary.
Lenders manage the risk of indirect lending by setting credit criteria for the dealers they work with and by monitoring early payment defaults. Poor underwriting at the dealership can lead to higher losses, so lenders may reduce their dealer reserve for weaker loans or stop doing business with a dealer altogether.
Regulators in many places watch indirect lending closely, especially for fairness in pricing. The core consumer protection is to ask for the full terms in writing, including the rate, the total cost and any fees, and to compare at least one outside quote.
In practice
Real-world examples.
Example
A family buys a used car and the dealer's finance manager sends the application to four lenders. The family accepts the lowest offer without realising that a credit union would have lent at a lower rate.
Example
A furniture retailer partners with a finance company to offer instalment loans on sofas and beds. Customers apply in the store, and the finance company funds the loan and collects the payments.
Example
A boat dealer arranges financing for a buyer through a marine lender. The dealer earns a share of the interest, and the lender gains a steady flow of qualified customers without running its own showroom.
Formula
Calculation
Monthly payment = Loan x r / [1 - (1 + r)^-n], where r is the monthly rate and n is the number of months
Dealer reserve cost to borrower = (Payment at contract rate - Payment at buy rate) x number of months
A buyer finances $30,000 over 60 months. The lender's buy rate is 5%, so r = 0.05 / 12 and the payment is about $566.14. The dealer offers the loan at a contract rate of 7%, so the payment is about $594.04. The monthly difference is 594.04 - 566.14 = $27.90, and over 60 months it adds up to 27.90 x 60 = about $1,674, which is the cost of the mark-up to the borrower.Case study
Seen in the real world.
Rivergate Motors is an illustrative, fictional car dealer that sends most of its customers to one finance partner. The dealer's finance manager used to add 2 percentage points to every buy rate as a standard reserve.
When a customer asked for a quote from his own bank, the dealer realised that many buyers were comparing prices and that the 2-point reserve cost it sales. The company changed its policy to cap the mark-up at 1 percentage point and to show the buy rate and contract rate to every customer.
Reserve income per loan fell, but the fictional dealership's volume rose by 15% and complaints fell. The illustrative lesson is that transparency can protect both the relationship and the long-run profit.
Watch out
Common mistakes.
- Accepting the dealer's financing without comparing it to a direct loan from a bank or credit union, which can miss a lower rate.
- Assuming the dealer is the lender, when the loan is usually sold to a bank or finance company that you will repay.
- Focusing only on the monthly payment, when a longer term can lower the payment and still increase the total interest paid.
Questions
People also ask.
What is the difference between a direct and an indirect loan?
In a direct loan the borrower applies straight to the lender, while in an indirect loan a dealer or other third party arranges the credit.
What is a dealer reserve?
It is the extra interest the dealer is allowed to add to the lender's minimum rate, which the dealer and lender share.
Can I negotiate the rate on an indirect loan?
Yes, because the contract rate often includes room above the buy rate, and a competing quote gives you leverage to ask for a lower one.
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