Car financing has become big business. A large number of new and used car buyers in the UK purchase their vehicles in one way or another. It may be in the form of a bank loan, dealer financing, leasing, credit cards, the trusted “Bank of Mum and Dad”, or countless other forms of financing, but relatively few people actually buy a car with their own money anymore.
A generation ago, a private car buyer with, say, £8,000 in cash to spend would normally have bought a car worth £8,000 in cash. Today, that same £8,000 is more likely to be used as a down payment on a car that could be worth many tens of thousands, followed by monthly payments for up to five years.
With several manufacturers and dealers claiming that anywhere from 40% to 87% of car purchases today are made in one way or another, it’s not surprising that there are many people jumping on car financing to take advantage of the buyers’ desire to have the latest, flashiest car available within their monthly cash flow limits.
The appeal of financing a car is very simple: you can buy a car that costs a lot more than you can afford in advance, but that you can (hopefully) save over time with small monthly chunks. The problem with car financing is that many buyers don’t realise that they usually pay much more than the face value of the car, and they don’t read the fine print of car financing agreements to understand the implications of what they’re doing. You will need to re-register.
To clarify, this author is neither pro-nor anti-financial when it comes to buying a car. However, what you should be aware of is the full implications of financing a car—not just when you buy the car, but over the entire term of the financing and even beyond. UK regulators keep an eye on things, but they can’t make you read documents or make smart decisions about how to pay for your car.
Financing through the dealer
For many people, it is very convenient to finance the car through the dealer where you buy the car. There are also often national offers and programmes that can make financing the car through the dealer attractive.
This blog will focus on the two main types of car financing offered by car dealers to private car buyers: the Hire Purchase (HP) and the Personal Contract Purchase (PCP), with a brief mention of a third party, the Lease Purchase (LP). Leases will be discussed in another blog shortly.
What is a hire purchase?
An HP is like a mortgage on your house; you pay a deposit up front and then pay off the rest over an agreed period (usually 18–60 months). Once you have made your final payment, the car is officially yours. This has been the way auto financing has been working for many years, but is now starting to lose favour over the PCP option below.
There are several advantages to hiring a vehicle. It is easy to understand (deposit plus a number of fixed monthly payments), and the buyer can choose the deposit and the term (number of payments) to suit their needs. You can opt for a maximum term of five years (60 months), which is longer than with most other forms of financing. You can usually cancel the contract at any time if your circumstances change without huge penalties (although the amount owed early in the contract term may be worth more than your car is worth). You will usually pay less in total with an HP than with a PCP if you plan to keep the car after the financing is paid off.
The biggest drawback of an HP compared to a PCP is higher monthly payments, which means the value of the car you can usually afford is lower.
An HP is usually best for buyers who are planning to keep their car for a long time (i.e., longer than the financing term), have a large down payment, or want a simple car financing plan that doesn’t have a tail end at the end of the deal.
What is a personal contract purchase?
A PCP is often given different names from manufacturer finance companies (e.g., BMW Select, Volkswagen Solutions, Toyota Access, etc.), and is very popular, but more complicated than an HP. Most of the new car financing offers advertised today are PCPs, and usually a dealer will try to push you towards a PCP over an HP as 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 costs are lower and/or the term is shorter (usually max. 48 months) because you do not pay off the entire car. At the end of the term, a large part of the financing is still unpaid. This is commonly referred to as a GMFV (Guaranteed Minimum Future Value). The car financing company guarantees that the car is worth at least as much as the remaining financing within certain conditions. This gives you three options:
1) Return the vehicle.You will not receive a refund, but you do not have to pay the remainder. This means that you are actually renting the car all this time.
2/Pay out the remaining amount (the GMFV) and keep the car. Since this amount can be many thousands of pounds, it is usually not a viable option for most people (which is why they financed the car in the first place), usually leading to
3) Part-exchange the car for a new (or newer) one. The dealer assesses the value of your car and takes care of the payment of the financing. If your car is worth more than the GMFV, you can use the difference (equity) as a deposit on your next car.
The PCP is best suited for people who want a new or nearly new car and fully intend to change it at the end of the deal (or possibly even sooner). For a private buyer, it is usually cheaper than a lease or contract rental finance product. You are not committed to going back to the same manufacturer or dealer for your next car, as any dealer can pay out the financing for your car and close the deal on your behalf. It’s also good for buyers who want a more expensive car with lower cash flow than is normally possible with an HP.
The downside of a PCP is that it tends to lock you into a cycle of replacing your car every few years to avoid a big payout at the end of the deal (the GMFV). If you borrow money to pay off the GMFV and keep the car, you usually get a monthly payment that is a little cheaper than starting over on a new PCP with a new car, so it almost always tempts the owner to replace it with another car. This is why manufacturers and dealers love PCPs because they make you come back every 3 years instead of keeping 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 down payment and low monthly payments, such as a PCP, with a large final payment at the end of the agreement. However, unlike a PCP, this final payment (often referred to as a “balloon”) is not guaranteed. This means that if your car is worth less than the amount owed and you want to sell or trade it, you’ll have to pay out any difference (called “negative equity”) before you even think of putting a down payment on your next car.
Read the fine print.
What is absolutely essential for anyone buying a car with financing is to read and carefully consider the contract before signing anything. Many people make the mistake of buying a car with financial compensation and then finding themselves unable to make their monthly payments. Since your funding period could last for the next five years, it’s critical that you carefully consider what might happen in your life over the next five years. Many high-end sports cars had to be returned because of unplanned pregnancies, which can have big financial consequences for the people who own them!
Buying a car on financing means that you should think about and talk about all the different financing options that are out there and learn about the pros and cons of each one so that you can make smart money decisions.
Stuart Masson is the founder and owner of The Car Expert, an independent and impartial car buying agency in London for anyone looking to buy a new or used car.
Stuart was born in Australia, but he has been interested in cars and the automotive industry for about 30 years. He has worked in the automotive retail industry for the last seven years, both in Australia and London.
Stuart has combined his extensive knowledge of all things automotive with his own experience of selling cars and delivering high customer satisfaction to bring a unique and personal car buying agency to London. If you’re looking to buy a new or used car in London, the Car Expert can help you find the best deal.
