Full disclosure up front - not a car guy. I’m a big believer in prioritising spending based on what you really enjoy and value, and I have never really managed to get into cars.
Don’t get me wrong, I see the appeal, but having a really nice car just isn’t a priority for us. Which is lucky in some ways because it can be an expensive old endeavour.
Maybe because I’m not all that interested, car finance has always seemed a very murky world to me.
Having looked at a few deals over the years, I could never seem to get my head around the actual costs, and this annoyed me. If you can’t tell where you’re getting screwed, you’re really getting screwed.
So we are going on a voyage of discovery together this week and looking at each of the most common methods of financing a new car, including the advantages and disadvantages of each.
Personal Contract Purchase (PCP)
PCP involves paying an initial deposit followed by fixed monthly payments over an agreed-upon term, typically two to four years.
At the end of the term, you're faced with a decision: return the keys and walk away, or make a final “balloon payment” to take ownership of the vehicle.
The appeal of PCP lies in its flexibility and affordability. You don’t have to decide whether to take ownership of the car outright until the end of the term, and these agreements will often offer low monthly payments relative to the quality of the car.
However, there are costs to entering into a PCP arrangement - and these may not be immediately obvious.
When you take out a PCP agreement your monthly payments cover the expected depreciation of the car during the term of repayment, and car finance companies tend to be pretty conservative with their estimates of depreciation. However if the car turns out to be worth more than expected at the end of the term, you can always trade it in to get cash off another car, or take ownership of the vehicle and attempt to sell it privately yourself.
Interest is also often charged on the total amount borrowed. Even if you don’t end up paying the balloon payment at the end of the term, the interest on this payment is included within the monthly payments as well.
The net result of this is that the total interest payable on a PCP arrangement will often be higher than for an equivalent Hire Purchase. And paying interest means wasted money.
In addition, because you don’t own the vehicle until you make the balloon payment, your use of the car is subject to certain restrictions like agreed mileage limits. If you exceed these, or return the car damaged, there can be hefty fees to pay.
Hire Purchase (HP)
If PCP is the flashy sports car, then Hire Purchase is the dependable family estate.
With HP, you're on the path to ownership from day one, making fixed monthly payments over a set period until you've paid off the full value of the car. There is no final balloon payment. It is a simple and relatively transparent method of financing a car purchase.
Hire Purchase agreements are also available on a wider range of cars than PCP, which is typically only available on cars less than five years old. The reason for this is that depreciation on older cars is harder to project and this highlights a key risk of Hire Purchase to the consumer - you are taking on the risk that the car might have depreciated by more than expected by the time that you come to own it. In a PCP arrangement, the finance company/dealer takes on this risk.
The interest payable on a Hire Purchase agreement is often less than for a PCP, and you can often make early repayments without charge if you wish - further reducing the interest you will pay.
However while HP offers the security of ownership, as you are paying off the full value of the car the monthly payments tend to be higher compared to PCP.
Additionally, until you have made the final payment, you are also unable to modify or make any changes to the car without the lender’s express agreement either.
Personal Contract Hire (PCH) or Leasing
Given the rise of a “subscription mindset” amongst consumers it should be no surprise really that leasing has become more popular in recent years.
Similar to PCP, PCH involves putting down an initial payment before paying a monthly charge to use a car over a fixed period of time. Unlike PCP however, there is no option to buy the car outright at the end of the agreement - you are only ever hiring it.
The main advantage of leasing, which is primarily only available on new cars, is that it offers access to the shiny new thing through relatively low monthly payments.
Additional costs such as maintenance, road tax and insurance are also often included in the monthly cost - useful if a trip to the mechanics is your idea of hell.
The other benefit of leasing is that you don’t need to pony up a large deposit or the full cost of the car up front. Therefore it frees up capital to deploy, ideally productively, elsewhere.
Ref the downsides - as you are only renting, rather than owning, you are never building up equity in the vehicle like you would be under a PCP or Hire Purchase arrangement. Lease payments each month cover the expected depreciation of the car, and although a car lease contract is not specifically required to highlight this, you will also be paying interest (which is often called by another name, the “lease money factor” or “lease fee”).
Although the monthly costs may seem low, you will absolutely be paying for convenience when leasing. It is important to remember this.
Under a leasing arrangement you also need to ensure that you stick to mileage limits, and the car needs to be returned in good condition. Otherwise there may be further fees to pay.
Buying Outright
For those who prefer to cut straight to the chase, there's the option to buy your car outright. If you want to own your car, buying with cash up front is unequivocally the cheapest method of doing so.
Buying outright is in many ways the simplest method - no finance agreements, no monthly payments, just pure ownership from day one. Plus, without the constraints of a finance agreement, you are free to customise or modify the vehicle as you wish.
However, forking over a substantial sum of cash upfront can be a daunting prospect for many, especially if it depletes your savings or leaves you financially stretched. It also ties money up in an asset which you might struggle to sell quickly in an emergency (and car prices typically get walloped during recessions).
The other downside of buying outright is that you will be assuming full responsibility for the vehicle's maintenance and upkeep. And unlike leasing or finance agreements, there is no safety net if the car encounters mechanical issues or depreciates in value by more than expected.
Buying With A Personal Loan
If owning a car from the get go appeals to you, but getting the cash together initially seems like too much of a stretch, then you may want to arrange your own independent finance.
Buying using this method is very similar to Hire Purchase, only you are obtaining finance from the bank rather than from the dealer/car finance company. Which may mean a better rate (a quick Google tells me that £30,000 unsecured loans are currently available at rates around 8%, subject to eligibility of course).
You own the car immediately upfront, and you can tailor the term of the loan to make repayments manageable.
Although rates are a lot higher than they used to be - this interest cost is at least clear and obvious. The only additional outgoings to be aware of are the usual costs of ownership and maintenance.
Access to this kind of finance may be dependant on a good credit rating, otherwise the interest on the loan may be punitively high. Failure to keep up with repayments could also knacker your credit rating.
The rules of personal finance 101 would state that it is best to own assets that appreciate in value (e.g. property) and lease assets that depreciate in value (e.g. a car).
But like so much when it comes to personal finance, it depends. It depends on your financial situation, your personal circumstances and the state of the car market at the given time.
It has been a funky few years for the market following COVID, where there was a massive under supply of new cars (due to semi-conductor shortages) - and therefore the cost of used cars skyrocketed.
Prices are now beginning to correct as the market re-adjusts, but this will naturally take time.
Source: Auto Trader
It is important to bear in mind that buying a car (I’m assuming that you won’t be purchasing a classic…) represents consumption rather than an investment.
It is therefore likely that factors that exist outside of the spreadsheet will take precedence.
How much of a priority is having a nice car to you? Do you want a new car, or are you happy with a used car? Given that 80% of car purchases made in the UK are of used cars, a new car would appear to be somewhat of a luxury.
Our (previously used) car does about 3,000 miles a year if that. I bought it originally in the midst of lockdown, mainly out of boredom. It exists primarily to ferry my clubs from one golfing disappointment to another.
When I bought it four years ago, interest rates were basically non-existent, and so I financed the purchase using a personal loan. From memory the rate was 3.4% p.a. which I recently paid off. As we have seen, these kind of rates are a thing of the past.
Barring a fairly major change in circumstances, it is our intention to run this car into the ground before changing.
Would I do the same again? I’m not sure I would.
I’m a big fan of convenience and therefore leasing naturally appeals, but the key advantage of a PCP or leasing arrangement to me is that it frees up capital to divert elsewhere. Say, towards buying income generating assets within a pension or ISA. And that to me is a better use of funds than tying up that money up in a depreciating asset.
Any questions, or tips, drop them into the comments.
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