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Fair Lending Compliance for Financial Institutions’ Indirect Auto Loans
Since 2013, the Consumer Financial Protection Bureau (CFPB) has focused on the requirement that indirect auto lenders comply with fair lending laws due to the risk in potential pricing disparities based on race, national origin, and potentially other “prohibitive bases.”
Most financial institutions have told us that they find it fairly easy to comply with these requirements for in-house loans, but indirect auto lending programs have been a bit more challenging due to the pressure received from auto dealerships.
Historically, a dealer markup program was the most common method used to compensate dealerships; however, the increased scrutiny on financial institutions’ fair lending programs has prompted some to rethink this compensation practice. Many auto dealerships prefer the dealer markup option, as it allows them to realize a larger return on most loans originated, but the financial institution assumes the majority of the fair lending risk.
Therefore, financial institutions should carefully examine the two methods used to compensate auto dealers for indirect loans, and decide which one is better at mitigating the risk of not complying with fair lending laws.
Flat fee payment method
The first, and lower risk method, is a flat fee payment for each loan purchased by the financial institution. The financial institution will set the interest rate for the loans to be purchased and the dealer has no discretion in altering the rate the borrower(s) will receive.
In this model, the financial institution typically pays the dealership a flat fee based on one or more of the following factors:
- Total amount of the loan.
- Credit worthiness of the borrower(s) (i.e., credit score).
- Year of the vehicle.
- Amount of miles on the vehicle.
This compensation model drastically reduces the fair lending risk associated with the transaction since the financial institution sets the interest rate and creates the underwriting criteria, and there is no incentive for differential treatment by the auto dealership.
Dealer markup method
The dealer markup method of compensation typically includes a combination of a flat fee and the ability of the dealership to increase the interest rate. The financial institution sets the base rate for the loan and the dealership is allowed to increase the rate, typically by 200 or 300 additional basis points, and keep most or all of the spread (additional interest earned on the loan) at its discretion.
These dealer markups are not credit based, as the dealership typically has no credit risk in the transaction once the loan has been purchased by the financial institution. Historical data has shown this compensation method increases the likelihood that similar applicants will receive different interest rates that are not based on the collateral or the borrower’s credit worthiness.
Dealerships may want to use this method in order to earn more profits, but ultimately the financial institution is liable for these practices if they result in disparate treatment or have a disparate impact on a borrower.
However, financial institutions may prefer to compensate the auto dealerships they work with through a dealer markup program because this typically will motivate the dealership to send more loans their way. In some areas it is difficult for a financial institution to offer a competitive indirect auto loan program without compensating the dealerships through a dealer markup program.
Fair lending program
If a financial institution choses the dealer markup method, it should consider implementing a robust fair lending program which includes the following:
- Maintaining ongoing communication with all dealerships it is purchasing loans from and informing them of their expectations concerning the dealer’s compliance with all requirements under Regulation B and the Equal Credit Opportunity Act.
- Conducting periodic reviews (monthly, quarterly, or annually depending on the size of the program) to determine if all applicants are being treated equally.
- Providing prompt restitution to any borrower who has been harmed by the dealership’s lending practices.
- Implementing a process to evaluate all dealerships it is working with and actions to take if it finds any form of disparate impact or treatment, including termination of the relationship.
Failure to properly mitigate the risks of an indirect auto lending program can open a financial institution up to substantial regulatory scrutiny. This was the case with American Honda Finance Corporation (Honda Finance), which recently agreed to pay $24 million in restitution to minority borrowers for discriminatory loan practices.
From 2011 to 2014, Honda Finance set a buy rate for all loans purchased from the auto dealers, and then allowed the auto dealers to mark the interest rate up an additional 200 - 225 basis points, depending on the term of the loan. As a result of this practice, it was identified that minority borrowers paid an additional $150 - $250 on average for their loans. This case demonstrates the negative effect a dealer markup program can have on a protected class and the liability the financial institution takes on in these compensation plans.
How we can help
CliftonLarsonAllen understands the fair lending laws for financial institutions purchasing loans through an indirect auto lending program, and can help assess whether your financial institution is at risk of non-compliance and provide guidance to help mitigate your risk.