How does a PCP work?
There are basically three components to a personal contract purchase: the intial deposit, the monthly payments, and the final payment.
Deposit (upfront payment)
As with an HP, a buyer will put down a deposit on their new car and finance the balance. With a PCP, there is a maximum deposit that is allowed (which varies from finance company to finance company), but usually it’s about 30% of the total price of the car. Your deposit can be cash or your current car as part-exchange (trade-in), or a combination of both.
The word deposit can be a bit confusing, as it implies that you may get it back later on. That’s not the case at all. When it comes to a car finance agreement, a deposit is simply an upfront payment. The more deposit you put in, the less money you are borrowing and the lower your monthly payments will be.
Monthly payments (term)
Most PCP deals are available for anywhere between 18 and 48 months. The most common has traditionally been 36 months, but we are seeing dealers and manufacturers gradually pushing customers towards 48 months instead.
As a general rule, longer terms give lower monthly payments, although it’s not necessarily a dramatic difference because longer terms have lower final balloon payments (which we address below).
Over the term of your PCP agreement, you make your regular monthly payments. These are automatically taken via direct debit from your bank account.
Final payment (balloon)
The final balloon payment, and the associated Guaranteed (Minimum) Future Value (GFV or GMFV), is the real key to how a PCP works.
As mentioned earlier, over the term of your agreement you are only paying back a portion of your debt. So going back to the hypothetical example we mentioned earlier, you may have borrowed £20,000 to start with, but by the end of your PCP agreement you may have only repaid £12,000 – and therefore still owe the finance company £8,000.
When you apply for a PCP, the finance company predicts what your car will be worth at the end of the agreement. Your deposit and monthly payments are paying off the depreciation – the difference between the initial buying price and this predicted value. This final value then needs to be paid to settle the finance agreement, either by returning the car or paying out the remaining amount.
The finance company guarantees that, subject to certain conditions, the value of your car at the end of the agreement will be at least the same as the final payment (hence, a Guaranteed Future Value). So if you don’t want to pay out the final amount, you can simply give the car back to the finance company instead and the finance is settled.
If the market value of the car is less than the amount outstanding, that’s not your problem – the finance company takes the loss.
What is is the Guaranteed Future Value (GFV)?
Before you start the finance agreement, the finance company needs to know what the value of the car is likely to be at the end of the agreement (the future value). They predict this by taking into account:
- the car you are buying (some options or features may slightly improve or reduce the final value of the car)
- the length of the agreement (obviously, a car will be worth less after four years than after three)
- your annual mileage (a car with 60,000 miles on the clock will be worth less than a car with 20,000 miles on it).
The finance company will use the future value this information to set the final balloon payment, and it will then guarantee the car’s value at that amount at the end of the agreement.
The finance company will set this future value reasonably low, as it is their loss if the value drops below what you owe on the car at the end of the agreement. The aim is that the car should be worth a bit more than what is owed at the end of the agreement.
What are my options at the end of the PCP contract?
So you are coming to the end of your PCP agreement and the finance company has written to you to remind you that you will have to settle the outstanding balance fairly soon. What are your choices? We have an article that explains these in a lot more detail, but this is the summary:
1) Give the car back. The finance company has guaranteed that the value of the car will be equal to the balance outstanding, so you can simply just give it back and walk away.
This is subject to a few conditions, namely; the car must not have exceeded its agreed mileage, it must have been serviced on time (and usually by the manufacturer), and there must be no repairs required beyond normal fair wear and tear.
If your car does not meet the conditions, there will be financial penalties. Effectively, you have treated you PCP like a lease.
2) Pay the outstanding balance, either in cash or by re-financing. You keep your current car and either pay off the balance from your savings or take out another loan to pay off the remaining balance.
Most finance companies will no longer allow you to re-finance the balloon and keep paying it off, which means you are likely to have to borrow the money from elsewhere (such as a personal loan from a bank).
3) Part-exchange your car with a dealer. It doesn’t have to be the same manufacturer or dealer where you bought the car. If the car is worth more than the balloon/GFV, this difference is called equity.
If your car is worth less than the balloon/GFV (called negative equity), you either give it back to the finance company (option 1) or you pay the difference.
Legally, you are not allowed to sell the car privately as it’s not yours to sell. Check with your finance company if you want to sell the car privately, as they may allow it if you comply with certain requirements about how they are paid as part of the sale.
If you part-exchange your car to a dealer, the dealer will settle your finance agreement as part of the process. If your car is worth more than the GFV, then any of that equity is yours to use as deposit towards your next car. Say you are offered £12,000 for your car, but your GFV is £10,000. The dealer will pay £10,000 to settle your finance and the remaining £2,000 is yours to put towards your new car.
This is the most common way to settle your PCP, and it is why dealers and manufacturers love it.
Continued on next page: Disadvantages of a PCP and other considerations