The history of finance is a long one and contains a lot of innovation, such of it beneficial to humanity’s economic progress and certainly all of it apparently beneficial to its immediate inventors. But cynicism aside, there’s certainly been many different finance options developed over the years and each one has its own acronyms, promotors and detractors.
Now financial innovation occurs when there is a need to shift risk to someone who can absorb it from someone who is relatively unwilling to keep it. Or perhaps it can be described as two parties swopping two different kinds of risk which enables both of them to achieve what they need. Anything more complicated than a simple loan is intended to move the risk from A to B and it would be a good thing, if a little idealistic, if everyone could understand this aspect of finance a little better. I might even argue that if everyone had understood collateralized debt obligations of asset-backed securities a little better, then we would never have had the financial crisis of 2008!
But leaving the jokes along with where we left our cynicism at the start, PCP car deals are something you should definitely take five minutes to understand if you are (like most people) going to need a car at some point. Most people would never need to understand the wild and snowy peaks of advanced corporate finance but in recent years there’s been some interesting variants – including PCP car deals – on old hire purchase and personal loans that regular people – the average consumer – would benefit from knowing something about.
There’s an urban myth floating around the car industry that the personal contract purchase and the entire spectrum of PCP car deals was invented by accident and through desperation. This was not a product of some smartypants in a bow-tie and suspenders on Wall Street, but a hybrid mixture of two other offerings that came about because one salesman was desperate for a deal – any deal, including something invented on the spot. Some say that’s how the best variations on cocktails came about too – a distracted barman mixes up the order slightly between a gin & tonic and a Bloody Mary and suddenly you have a Bloody Margaret. And somebody gets exactly a new favourite which they would never have known was just right for them.
Similarly, the Personal Contract Purchase is a mixture of Hire Purchase and a contract hire. Leaving aside simply borrowing the money as a car loan, these are the two main car finance options that a dealer would offer a potential customer for a new car. This mythical salesman of ours was extra keen to hit his sales quota and the only hitch was the customer’s concern over the eventual resale value of this new car. So the salesman agreed to sell him the car, but retain that risk himself. Actually, in this simplified story of the sort that gets told in bars, the salesman at the dealership was handling the financing himself and then was no funder involved.
(I will use 36 months as the contract length as an example but of course it could be between 24 and 60 months.) To explain how he did that and made his customer an offer he couldn’t refuse, it’s necessary to recap first the difference between a hire purchase and a contract hire. Most new personal car buyers in the UK would be familiar with a hire purchase on their new car, with a sticker price showing the total price, a monthly installment figure and an APR as a percentage. (This is mandatory and intended to ensure customers can compare and contrast the cost of their car financing.)
The customer pays the monthly installments as they drive the car, including the interest, and after the final payment in perhaps 60 months, they finally own the car outright. The hire purchase is likely cheaper than a bank loan for most as the dealer retains ownership of the car and it’s a relatively simple process to retake possession if the customer defaults on their payments. The contract hire is a version for private individuals of a form of financing that is very much more common for businesses. The financing company (unlikely to be the dealer themselves though it’s possible) retains ownership of the car and gains possession of it again once the contract period is complete. The financing company has effectively taken a bet on the eventual residual value of the new car after 36 or 48 months and leases the vehicle for a monthly payment to the private individual. Cars which retain their residual values well, most likely high-quality executive saloons, can be leased for much less each month than what a hire purchase agreement would demand.
However the customer has no right to purchase the vehicle at the end of the contract, though they may be allowed to do so. Let’s leave the various merits of these finance options to one side for the moment and return to our mythical salesman with a car on his lot to move and a customer worried about the resale value. This customer was apparently 80% convinced that he wanted to buy the car and so didn’t want to take the choice of contract hire and (as he saw it) ‘waste’ his money on purely a hire arrangement.
Perhaps it was a big roomy people-mover that he thought his family would grow into and not want to see go in three year’s time when it was almost a member of the family. So keep that image in your mind and at the same time this was a rather innovative vehicle that was either futuristic or a bit silly looking – depending on your point of view. So the 20% that wasn’t convinced was based on that unknown resale value and what it would be in three years time. And as everyone should know by now, buying new cars and then selling them three years down the line is simply a way to burn cash as the vehicle depreciates in front of your eyes. So the salesman offered him something new, which we will call (as we generally do here in the UK) a Personal Contract Purchase. He offered to ask the customer to pay less for the vehicle monthly than he would have under a hire purchase agreement for 36 months and then he would take the vehicle back.
So far, so like a contract hire, with the customer having no exposure to the resale value. However – and this is new – the customer had the guaranteed right to buy the vehicle for a single payment at the end of the contract term. This option to buy made the acquisition of the car as much like a purchase as any hire purchase agreement. It also meant that the customer didn’t have to explain to his nosey neighbours how a contract hire contract worked and it was actually better than buying a new car. And it meant that the people-mover was guaranteed to be allowed to stay part of the family if the family so wished.
So – the best of all possible worlds? Well, for this customer certainly, but nothing (especially peace of mind) comes for free in this life and freedom from the second-hand vehicle market pricing risk does cost something. A personal contract purchase costs more per month than a contract hire on the same car and if the customer ultimately buys the vehicle, then it will have cost more for the total purchase than a hire purchase would have done. So, you don’t get something for nothing but it’s not a big difference and it does suit some people’s needs.
And our mythical car salesman? Well, apparently when the customer returned the car 36 months later, he’d made more than he would have under a contract hire and he was happy. Or the other version of the story has the customer keeping the car, the salesman doing the sums and realising it was a really good hire purchase deal from his perspective. But either way, the salesman realised that he had a winner on his hands and continued to offer such deals. And they continued to work out for him – just as long as the eventual residual value had been estimated well at the start! Car leasing is by now an accepted part of the car industry here in the UK and anyone looking at a new car will probably consider contract hire instead. They should definitely also look at all the available PCP car deals at the same time.
Tags: best PCP deals, car leasing, contract hire, contract purchase, finance a car, financeacar, personal contract purchase