In various previous articles, I have covered why Difference in Charges (DiC) commissions should, in general, be in customers’ interests.
Given the interest in this, and the further information issued by the FCA yesterday on its review of commissions in the motor finance market that reports suggest could lead to car finance lenders having to pay up to £13 billion in compensation payments (as reported here by the Financial Times), here is a summary of the reasons why DiC (usually) works well.
1. Paying commissions to intermediaries typically reduces the cost of a credit agreement
Any financial product sold to a consumer requires expenditure on promotions (so the consumer is aware of it), providing information (so the consumer understand it and can make an informed decision that is in their interests) and application processing.
If these activities are not carried out by an intermediary, such as a car dealer or specialist car finance broker, they can be done by the lender.
But the lender who deals directly with consumers will often have higher costs. Direct distribution costs such as search engine advertising, paying for leads from websites, and telesales will often exceed £1,000 per completed credit agreement. Savings on distribution by using intermediaries should feed through to lower costs for credit agreements.
2. Commissions are typically eminently reasonable given the work involved
In most cases, dealer commissions (whether calculated using DiC or any other method) on used cars have been in the hundreds, rather than thousands, of pounds. It reflects the time spent by the dealer staff in discussions with customers, handling applications, training and (increasingly) compliance. Plus, of course, a modest profit margin on that investment.
3. In a competitive market, dealers cannot systematically overprice
Economic theory suggests that in a competitive market customers should be able to obtain a good price. With around 8,000 car dealers in the UK offering used cars, plus the alternative of private sales, we can expect most consumers to leave the dealership with a fair deal on both their vehicle and the finance.
A caveat is that even in a generally competitive market, there can be weaker competition at the ‘point of sale’. In a car dealership, only one person - the dealer - offers a finance option that can be signed on the spot. So, is there an argument that allows the dealer to increase prices?
In this market, that seems unlikely. Customers are likely to be comparing cars available from different dealers and can typically easily compare the average finance rates being promoted. There are also plenty of alternatives constantly promoted in the market, including loans from the customer’s bank and other lender and brokers.
There may well be a case for looking carefully at wider competition in the market. There is a particular issue, for example, with some car dealers refusing to cooperate with customers who want to use an external car finance broker.
So a wider review of car finance may well be justified, including commission models (see conclusion, below). But the fact remains that, overall, it’s very difficult to argue that consumers buying and financing their cars are anything other than extremely price conscious.
4. Safeguards protected consumers
Despite economic forces, it is theoretically possible under DiC that a non-ethical car dealer could exploit a more vulnerable consumer, by charging a higher rate. Of course, the same can happen with the purchase of any good or service by that consumer where the retailer or service provider sets the price.
To help mitigate this (small) risk, most car finance providers limited the maximum rate that their introducers could set under DiC and would have been monitoring the average rate and comparing it between different dealers to identify any possible outliers and issues.
5. Alternative ‘one size fits all’ commission models can be worse for consumers
The obvious alternative to a DiC model is that the lender sets the rate the customer will pay and tells the broker how much they will earn. This can cause two main problems.
First, many dealers or brokers would previously have set their commission at the bottom of the range available under DiC to deliver a lower rate to the consumer, and the new rates result in higher prices.
Second, it can become uneconomic to help consumers who may require extra support, perhaps because their credit history has some issues. Finding the most competitive rate for such customers (noting that these are obviously more prevalent for used car finance as compared to new car finance) takes time.
Under DiC, that time could be rewarded through a higher commission charge but if that’s not an option the customer may be advised to find their own finance - and end up paying a much higher rate with a non-prime direct lender.
6. Average rates for used car finance have been increasing faster than underlying base rates
It’s impossible to fully isolate changes to commission models from other factors, but the used car finance market is slowly but steadily shifting away from prime bank providers to non-prime alternative lenders. According to my research for Apex Insight, the non-prime share of the market doubled from 2014 to 2019.
Since 2019, several leading prime lenders have moved out of the dealer used car finance market, while there has been strong growth from non-prime lenders while the remaining prime lenders appear not to have been growing. Apex Insight will update its research soon.
In summary, it seems very likely that average rates on used car finance have been growing more than underlying base dates, with many consumers who would previously have been able to access prime rates now having to borrow from a non-prime lender. If DiC commissions were a general cause of higher finance costs, we would have expected rates to have fallen relative to base rates since the DiC model was first confirmed as a concern by the FCA in 2018 and then banned in 2021.
The need for a wider market review
In the context of reduced choice in the market, apparently higher prices, falls in the share prices of banks, and general uncertainty over the regulators' positions (FCA and FOS), I believe the time has come for a wider economic review of the state of the market.
In a previous blog, I suggested this might come from a full review by the Competition Appeals Tribunal in response to the collective action case that was filed last August.
But on the basis of recent developments, I believe the Government should now refer the used car finance market to the Competition and Markets Authority for a market investigation.
In my view, this would establish once and for all that firms' use of DiC was actually - in general - in the interests of consumers, as well as investigating other factors that could lead to improvements in the market, including a ban on dealers refusing to cooperate with brokers and lenders that the customer has decided to use.
For more analysis of the used car finance market see my consumer credit market resources