Car finance has become a big business. Many new and used car buyers in the UK are purchasing on finance. It might be in the form of a bank loan, finance from the dealership, leasing, credit card, the trusty’ Bank of Mum & Dad’, or myriad other forms of finance, but relatively few people buy a car with their cash. A generation ago, a private car buyer with, say, £8,000 money to spend would usually have purchased a vehicle up to the value of £8,000. Today, that same £8,000 is more likely to be used as a deposit on a car worth tens of thousands, followed by up to five years of monthly payments. With various manufacturers and dealers claiming that anywhere between 40% and 87% of car purchases are today being made on finance of some sort, it is not surprising that there are lots of people jumping on the car finance bandwagon to profit from buyers’ desires to have the newest, flashiest car available within their monthly cash flow limits. The appeal of financing a car is very straightforward; you can buy a car that costs a lot more than you can afford up-front but can (hopefully) manage in small monthly chunks of cash over some time.
The problem with car finance is that many buyers don’t realize that they usually pay far more than the face value of the car, and they don’t read the fine print of car finance agreements to understand the implications of what they’re signing up for. For clarification, this author is neither pro- or anti-finance when buying a car. What you must be wary of, however, are the full implications of financing a car – not just when you buy the vehicle, but over the full term of the finance and even afterward. The industry is heavily regulated in the UK, but a regulator can’t make you read documents carefully or force you to make prudent car finance decisions.
Financing through the dealership
For many people, financing the car through the dealership where you are buying the car is very convenient. There are also often national offers and programs that can make financing the car through the dealer attractive. This blog will focus on the two main types of car finance offered by car dealers for private car buyers: the Hire Purchase (HP) and the Personal Contract Purchase (PCP), with a brief mention of a third, the Lease Purchase (LP). Leasing contracts will be discussed in another blog coming soon.
What is a Hire Purchase?
An HP is quite like a mortgage on your house; you pay a deposit up-front and then pay the rest off over an agreed period (usually 18-60 months). Once you have made your final payment, the car is officially yours. This is how car finance has operated for many years, but it is now starting to lose favor against the PCP option below.
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There are several benefits to a Hire Purchase. It is simple to understand (deposit plus several fixed monthly payments), and the buyer can choose the warranty and the term (number of payments) to suit their needs. You can select a period of up to five years (60 months), which is longer than most other finance options. You can cancel the agreement anytime if circumstances change without massive penalties (although the amount owing may be more than your car is worth early on in the agreement term).
Usually, you will pay less with an HP than a PCP if you plan to keep the car after the finance is paid off. The main disadvantage of an HP compared to a PCP is higher monthly payments, meaning the value of the car you can usually afford is less. Therefore, an HP is usually best for buyers who plan to keep their vehicles for a long time (i.e., longer than the finance term), have a large deposit, or want a simple car finance plan with no sting in the tail at the end of the agreement.
What is a Personal Contract Purchase?
Manufacturer finance companies often give a PCP other names (e.g., BMW Select, Volkswagen Solutions, Toyota Access, etc.) and are very popular but more complicated than an HP. Most new car finance offers advertised these days are PCPs, and usually, a dealer will try and push you towards a PCP over an HP because it is more likely to be better for them. Like the HP above, you pay a deposit and have monthly payments over a term. However, the monthly payments are lower, and the time is shorter (usually a maximum of 48 months) because you are not paying off the whole car. In the end, a large chunk of the finance is still unpaid. This is usually called a GMFV (Guaranteed Minimum Future Value). The car finance company guarantees that, within certain conditions, the car will be worth at least as much as the remaining finance owed. This gives you three options:
1) Give the car back. You won’t get any money back, but you won’t have to pay the remainder. This means that you have been renting the car the whole time.
2) Pay the remaining amount owed (the GMFV) and keep the car. However, given that this amount could be many thousands of pounds, it is not usually a viable option for most people (which is why they were financing the car in the first place), which generally leads to…
3) Part-exchange the car for a new (or newer) one. The dealer will assess your car’s value and handle the finance payout. If your vehicle is worth more than the GMFV, you can use the difference (equity) as a deposit on your next vehicle.
The PCP is best suited for people who want a new or near-new car and fully intend to change it at the end of the agreement (or possibly even sooner). For a private buyer, it usually works out cheaper than a lease or contract hire finance product. You are not tied into going back to the same manufacturer or dealership for your next car, as any dealer can pay out the finance for your car and conclude the agreement on your behalf. It is also good for buyers who want a more expensive car with a lower cash flow than is usually possible with an HP.
The disadvantage of a PCP is that it tends to lock you into a cycle of changing your car every few years to avoid a large payout at the end of the agreement (the GMFV). Borrowing money to pay out the GMFV and keep the car usually gives you a monthly payment much cheaper than starting again on a new PCP with a new car, so it nearly always sways the owner into replacing it with another vehicle. For this reason, manufacturers and dealers love PCPs because they keep you coming back every three years rather than supporting your car for 5-10 years!
What is a Lease Purchase?
An LP is a bit of a hybrid between an HP and a PCP. You have a deposit and low monthly payments like a PCP, with a large final price at the end of the agreement. However, unlike a PCP, this final payment (often called a balloon) is not guaranteed. If your car is worth less than the amount owed and you want to sell/part-exchange it, you would have to pay any difference (called negative equity) before considering spending a deposit on your next car.
Read the fine print.
What is essential for anyone buying a car on finance is to read the contract and consider it carefully before signing anything. Many people make the mistake of buying a car on finance and then cannot make their monthly payments. Given that your financial period may last for the next five years, it is critical that you carefully consider what may happen in your life over those next five years. Because of unexpected pregnancies, many heavily financed sports cars have had to be returned, often with serious financial consequences for the owners!
As part of purchasing a car on finance, you should consider and discuss the various options available and make yourself aware of the pros and cons of different car finance products to ensure you make informed decisions about your money. Stuart Masson is the founder and owner of The Car Expert, a London-based independent and impartial car-buying agency for anyone looking to buy a new or used car.
Originally from Australia, Stuart has had a passion for cars and the automotive industry for nearly thirty years and has spent the last seven years working in the automotive retail sector in Australia and London. Stuart has combined his extensive knowledge of car-related things with his experience selling cars and delivering high customer satisfaction to bring a unique and personal car-buying agency to London. The Car Expert offers specific and tailored advice for anyone looking for a new or used car in London.