What are the different PCP Car Finance Commission Arrangements?

Different Commission Arrangements by Brokers

In their Consultation Paper (CP19/28) Motor finance discretionary commission models and consumer credit commission disclosure, the FCA proposes banning, what they call, ‘discretionary commission models’ in the motor finance market.

These commission arrangements are proposing to be banned because they directly link the amount of commission received by the broker to the interest rate that the customer pays on the loan. Furthermore, it is the broker that has the power to set or adjust the level of interest.

The three most typical types of discretionary commission models are:

Increasing Difference in Charges (Increasing DiC)

This is also known as ‘Interest Rate Upward Adjustment’. Under this arrangement, the contract between the lender and the broker sets a MINIMUM interest rate. The fee/commission is a proportion of the difference in interest charges between the actual rate and the minimum rate.

For example, if the lender sets a minimum interest rate of 3% APR and the broker agrees an interest rate of 6% APR with the borrower, then the fee/commission paid to the broker is calculated to be (6%-3%) = 3%. As you can see, the higher the interest rate charged to the borrower, the higher the difference between this figure and the minimum interest rate, so the higher the commission payable to the broker. This can result in the borrower being overcharged interest.

Reducing Difference in Charges (Reducing DiC)

This is also known as ‘Interest Rate Downward Adjustment’. Under this arrangement, the contract between the lender and the broker sets a MAXIMUM interest rate or what is called the ‘Lender recommended rate’. Here, the fee/commission is determined by the level of interest charges set by the broker which will lie somewhere between the maximum interest rate and the minimum acceptable rate.

Scaled Commission

This is also known as a ‘Variable Product Fee’. Under this arrangement, the broker is paid a fee which varies (within a range of maximum interest rate and minimum interest rate) according to the interest rate agreed with the customer.

For example, if the lender sets a maximum interest rate of 7% APR and minimum acceptable rate is 2% APR, if the broker agrees an interest rate of 6% APR with the borrower, then the commission payment will be linked to the 6%. Again, it can easily be seen that the broker has an incentive to set an interest rate as high as possible, up to the maximum interest rate. This can result in the borrower being overcharged interest.

As can be seen from the different discretionary commission models, the Increasing DiC, reducing DiC and Scaled models can potentially provide powerful incentives for brokers to arrange finance at higher interest rates the commission that the lender pays them increases with the interest rate that the customer is ultimately charged. Furthermore, the broker also has the power, or discretion, to set the interest rate payable by the customer within certain limits set by the lender.

These discretionary commission models should be contrasted with the “Flat Fee” model whereby the lender pays the broker a flat rate of commission and the interest charge on the loan is fixed. Here the dealer/broker has no control in setting the interest rate on the loan.

What is the problem with discretionary commission models?

In addition to the obvious issue that discretionary commission models provide an incentive for brokers to set interest rates at higher levels on the car financing, these discretionary models also break the link between credit risk and price.

Typically, the higher someone’s credit risk (e.g. low credit score), the higher the cost of credit or higher interest rate charged. This is usually the case with the sub-prime consumer loan sector, such as pay day loans, where loans are provided to customers with low credit scores at high rates of interest. The lender can justify charging a high rate of interest as there is a higher change that the consumer will not make their monthly payments on time, or even default on the loan itself.

A study by the FCA found that even after controlling for other factors that one might think would have an impact on interest costs such as the customer’s credit score, the size of the loan or the length of the loan agreement, these incentives still retained a significant effect on the cost of motor finance for customers. 

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