(Adds background on CFPB investigation, details on loan payment and insurance plans)
By Patrick Rucker
WASHINGTON, Aug 29 (Reuters) - A unit of European lender Banco Santander SA has agreed to settle claims by a U.S. consumer watchdog that it misled drivers about the costs of loans and the coverage of related insurance policies, said three people with direct knowledge of the settlement.
Santander Consumer USA Holdings Inc, an affiliate of the Spanish banking group, allowed borrowers to make interest-only monthly payments without explaining that doing so would increase the total cost of the loan, the people familiar with the Consumer Financial Protection Bureau (CFPB) sanction said this week.
The lender also failed to explain to customers how an insurance policy known as "guaranteed auto protection" (GAP) would not always cover the costs of replacing a car that was destroyed in an accident.
Santander Consumer has agreed to pay a fine and strengthen its consumer protections, said the sources. Reuters could not ascertain the size of the fine.
A spokeswoman for Santander Consumer declined to comment on any possible settlement but said the lender has in recent months improved its consumer protection controls. A spokesman for the CFPB said the agency does not comment on enforcement actions.
Santander Consumer stopped offering its own GAP insurance product last year and the lender regularly reviews its disclosures to consumers, said spokeswoman Raschelle Burton.
The CFPB settlement, which could be announced as soon as on Wednesday, closes an investigation begun more than a year ago by Richard Cordray, the Obama-era CFPB chief who had been poised to sue the bank, Reuters reported last year.
Mick Mulvaney, U.S. President Donald Trump's budget chief who has served as the head of the CFPB since November, continued with the probe and ultimately decided to settle, the sources said.
Santander Consumer is a leading provider of high-cost auto finance loans to low credit or "subprime" borrowers.
More than 70 percent of its customers are subprime borrowers who typically pay double-digit interest rates for car-buying credit, according to U.S. regulatory filings and research from credit rating agency Experian.
Drivers could lower their monthly payments by about 40 percent under Santander's Temporary Reduction in Payment Plan (TRIPP), which allowed them to pay interest only for a time. But the CFPB found that the lender did not explain how interest-only payments would actually expand the life and cost of the loan.
The lender marketed the product aggressively, the CFPB found, leading more than 10 percent of Santander borrowers to tap the program within a year of a car purchase, according to a Santander investor presentation.
Many borrowers who turned to Santander Consumer for GAP insurance were surprised to find that there was a cap to the total amount of coverage, the CFPB also found.
Americans are borrowing more to buy a car and taking longer to pay back that loan, according to credit bureau Experian.
The total amount of auto debt outstanding has increased 53 percent in the last five years to $1.24 trillion, according to data from the Federal Reserve Bank of New York, with much of that packaged up as asset-backed securities. (Reporting By Patrick Rucker; Editing by Steve Orlofsky and Meredith Mazzilli)