In the United Kingdom, many people who buy cars do so using some form of financing. Few people today pay cash for a car outright. Instead, they use some form of financing, such as a bank loan, dealership financing, leasing, credit card, or even the tried-and-true “Bank of Mum and Dad.”
A private buyer with, say, £8,000 in cash would have purchased a car up to the value of £8,000 a generation ago. These days, an individual is more likely to use that same £8,000 as a down payment on a car that costs tens of thousands of dollars and then make monthly payments on it for up to five years.
It’s no surprise that many people have jumped on the car financing bandwagon to capitalize on customers’ desires to have the newest, flashiest car available within their monthly cashflow constraints, with estimates ranging from 40% to 87% of car purchases being made on some sort of finance today.
The allure of auto financing is simple to understand: it enables you to purchase a car that costs more than you can afford all at once, but that you (hopefully) can afford in manageable monthly chunks of cash over a period of time. Many people who finance cars don’t read the fine print of their contracts, so they end up paying significantly more than the sticker price.
This writer is neutral on the use of financing when purchasing a vehicle. However, you should be cautious about the long-term consequences of auto financing, not just at the time of purchase. 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.
Dealer-arranged Financing
It is convenient for many people to get auto financing from the dealership they plan to buy their car from. Furthermore, there are sometimes national offers and programs that can make financing the car through the dealer a more appealing choice.
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) (LP). Soon, we’ll have a blog post dedicated to leasing agreements.
What exactly is a Hire Purchase?
To put it simply, an HP is very similar to a mortgage in that you make an initial down payment and then spread the remainder of your payments out over a set number of months (usually 18-60 months). When the last payment is made, you own the vehicle outright. For a long time, this was the norm for financing automobiles, but the popularity of PCP (personal contract purchase) plans has been on the rise.
A Hire Purchase arrangement has several advantages. It’s easy to understand (deposit plus fixed monthly payments), and the buyer can tailor the terms to their needs by adjusting both the deposit and the number of payments. The maximum loan term is five years (60 months), which is significantly longer than the terms offered by competing financing plans. If your situation changes, you can usually terminate the contract without incurring any significant costs (although the amount owing may be more than your car is worth early on in the agreement term). If you want to keep the car after the financing is paid off, the total cost will be less with an HP than with a PCP.
When comparing HP and PCP, the main drawback is that HP typically requires higher monthly payments, reducing the maximum car value that can be afforded.
Buyers who have a sizable down payment, don’t mind making regular payments, and don’t mind a simple car financing plan with no hidden fees or penalties at the end of the agreement are the best candidates for an HP.
Exactly what is a P.C.O., or Private Contract Sale?
As a popular but more involved alternative to an HP, a PCP goes by many different names from different manufacturer finance companies (e.g. BMW Select, Volkswagen Solutions, Toyota Access, etc.). These days, PCPs are more commonly advertised than HPs for purchasing a new car, and dealers will often try to steer you toward a PCP rather than an HP because the former is more profitable for them.
This HP is very similar to the one we just discussed in that there is an initial payment followed by regular payments over time. In exchange for not having to pay the car off immediately, you get lower monthly payments and/or a shorter term (typically up to 48 months). There is still a significant portion of the financing outstanding after the term has ended. It’s common practice to refer to this as a GMFV (Guaranteed Minimum Future Value). The auto finance company offers a guarantee that, under certain conditions, the vehicle’s resale price will cover all outstanding debt. This provides you with three potential outcomes:
1) Please return the vehicle. Though you won’t receive a refund, you also won’t have to cover the difference. This amounts to nothing more than a long-term car rental on your part.
2) You can settle up for the GMFV and keep the vehicle. Since this sum could be in the tens of thousands of pounds (hence the need for financing in the first place), most people would be unable to afford it outright.
3), trade in part of the vehicle for a brand new one. Your car’s value and finance payoff will be determined by the dealer. If the value of your car is higher than the GMFV, you can put that amount toward the purchase of your next vehicle.
In order to get the most out of the PCP, you should only consider it if you are in the market for a brand-new or nearly-brand-new vehicle and plan to upgrade at the end of the contract (or possibly even sooner). In most cases, a private buyer can save money by purchasing rather than leasing or contract hiring through a financial institution. A dealer of your choice can pay off your auto loan and close the deal on your behalf, so you aren’t locked into buying from the same manufacturer or dealership again. Buyers who want a more expensive car but a lower monthly payment than is typical with an HP will also benefit from this option.
The primary drawback of PCPs is that they force you into replacing your vehicle every few years to avoid making a large payment at the end of the contract (the GMFV). In almost all cases, the monthly payment for borrowing money to pay out the GMFV and keeping the car is only slightly less expensive than starting over on a new PCP with a new car, so the owner opts to replace the vehicle instead. PCPs are popular with automakers and dealers because they encourage customers to trade in their vehicles every three years rather than keeping them for five to ten years.
Lease-to-own: What’s the Deal?
When compared to both the HP and the PCP, the LP is something of a compromise. Similar to a PCP, you make small payments on a regular basis and a large balloon payment when the contract is up. On the other hand, this last installment (also known as a “balloon payment”) is not assured, unlike a permanent credit plan. If you want to sell or part-exchange your car but its value is lower than what you owe on it, you will have to come up with the difference (called negative equity) before putting down a deposit on a new vehicle.
To avoid unpleasant surprises, it’s important to read the fine print.
Anyone getting a car loan must read the paperwork and give it serious thought before signing anything. Many people make the bad decision to finance a car purchase, only to later find themselves unable to keep up with the required monthly payments. Due to the possible length of your finance period (up to five years), it is essential that you give serious thought to the various scenarios that could play out during that time. Unexpected pregnancies have forced the return of many expensive sports cars, often with disastrous financial consequences for their owners.
If you’re planning on buying a car with a loan, it’s in your best interest to weigh all of your financing options and talk to a financial advisor about what’s best for your situation before committing to any one plan.