If you are concerned about your finances as a result of the coronavirus pandemic, there is help and guidance available. Your finance company should offer you a three-month payment deferral on your car finance agreement. Make sure you also read our exclusive analysis of this payment holiday initiative to decide if it is right for you.
Most car dealerships are rubbish at explaining how various car finance products work. This is clear from the amount of traffic this site receives from UK car owners and car buyers every day.
Today we are answering one of the most common PCP finance agreement questions: What if I want to terminate the agreement and settle my PCP early?
There is a lot of confusion about ending a PCP agreement early, and a lot of that confusion comes about because people are looking for easy answers that simply don’t exist. In reality, it’s quite simple. You have borrowed a large amount of money to buy a car, and that money needs to be repaid.
You can repay this at any time if you have the money available to do so. However, the reality is that most people don’t have the thousands of pounds usually required to settle their finance and are looking for other options.
How does a PCP work again?
A lot of the confusion about settling a PCP early comes from borrowers’ misunderstandings about how a PCP actually works in the first place.
When you take out a PCP, you will usually put in an upfront payment (referred to as a deposit) and borrow the rest of the money required to pay for the car. So if the car costs £30,000 and you put in £2,000 deposit, you will borrow the remaining £28,000. The finance company pays the dealer £28,000 and you get to drive home in your new car.
At this point, you will owe the finance company £28,000 plus interest and fees – let’s call it a nice round £30,000. This is your debt, and it needs to be repaid. Until it is repaid in full, the car remains the property of the finance company.
To repay this debt, you will have three to four years of monthly payments and then a balloon payment. In this example, that would probably mean monthly payments of £400-£500 and a balloon payment that’s probably somewhere between £10,000 and £15,000.
The key to a PCP is that the finance company offers a guaranteed (minimum) future value to cover the balloon amount. That means you can give the car back at the end of the agreement, or part-exchange it with a car dealer on another vehicle, instead of paying off the balloon. However, that only applies at the end of the agreement, not during the agreement.
A PCP is designed to work out neatly if you run it for the full term of the contract. If you want to settle up early and get rid of your car, it’s not so simple. You will probably find you have a negative equity problem thanks to the car’s depreciation.
What are depreciation and negative equity?
From the moment you drive off in your new (or used) car, it starts losing value. This is called depreciation, shown in the blue line below. The car loses value more quickly early on, because the price you pay for a car from a dealer will include the cost of the car plus the dealer’s costs and profit margin, plus a large dose of VAT if it’s a new car. Over time, the rate of depreciation starts to slow, which you can see as the blue line starts to flatten out.
The “cost of purchase” (dealer’s costs and profit margin) push up the price you pay but they don’t add any value to the car, so once you drive away from the dealership your car is potentially worth thousands of pounds less than what you just paid for it.
Your monthly payments, of a few hundred pounds each month, gradually reduce your settlement figure (the red line above) over time. But because your monthly payment is fixed, this amount reduces in more or less a fixed amount each month, which is why the red line above is a straight line.
For the first year or more of your finance agreement, your car’s value is falling by more than you are repaying. This creates what is called negative equity (the grey area in the graph above; it’s simply an example and the actual result will be affected by many factors).
Negative equity is what you get when you owe the finance company (the settlement, in red) more than what your car is worth (the value, in blue). On a PCP, you spend almost all of your time in negative equity. Even if you were able to sell your car (and legally it’s not yours to sell), the money you would get for it wouldn’t cover your debt.
In theory, the value of your car and the amount you owe the finance company should come back together again towards the end of the agreement. At any point before that time, you will have negative equity.
What does that mean if I want to settle early?
Generally, it means you have a problem. You owe thousands of pounds (all your remaining monthly payments, plus the balloon amount, minus some minor interest savings), which you probably don’t have in your bank account.
Let’s look at the simple example graph above, which is based on borrowing £30,000 and having a GFV of £15,000 after three years. If you wanted to try and get out of your agreement after one year, you would owe £25,000 (actually slightly less because you would save a few hundred pounds on interest by settling early). If you want to settle after two years, you’d owe £20,000 (again, it would actually be slightly less).
You’re almost certainly not allowed to sell your car privately, because it’s not yours to sell. Some finance companies will allow it under certain circumstances, but will probably require the buyer to pay them directly, rather than paying you and then you paying the finance company.
Usually, a finance company will allow you to sell the car to a dealer because the dealer will settle the finance. However, a dealer will usually want to sell you another car rather than simply buying yours, so finding one that will buy your car and settle your finance may be difficult.
And even if you are able to sell the car, its value will be significantly less than your settlement figure, so you’d still be a few thousand pounds short. You would have to pay those few thousand to either the finance company or the dealer before the debt is considered settled.
Will my car ever be worth more than the settlement?
The whole point of a PCP is to guarantee the value at the end of the agreement (guaranteed future value – GFV). This means that if the car’s market value is less than the GFV, the finance company will lose money. As a result, they will want to make sure they are not setting the GFV too high. So it is possible that the car could be worth more than the GFV at the end of the agreement.
It certainly used to be the case that finance companies were quite conservative in their GFV predictions, and customers would end up with a car that was worth a handy sum more than the settlement figure (called equity or positive equity, and obviously the opposite of negative equity). This money would almost certainly be used as a deposit for another PCP agreement, so it all worked out happiily for both buyer and lender.
However, as the market has become more competitive, the situation has changed. More finance companies appear to have increased their GFV predictions, while at the same tie used car values have been falling. This has kept your monthly payments down a bit but it has made it much less likely that you will have any equity in the car at the end of the agreement or any point during the agreement.
It is now very unlikely you can ever settle a PCP early and be in a position where your car is worth more than you owe. There will be exceptions, but as a general rule you should always assume that you will be in a negative equity position.
What about voluntary termination?
Every PCP agreement has a clause built in outlining your termination rights. This provides you with the right to give the car back once you have paid off half of the total amount payable. Voluntary termination is looked at in detail here.
However, due to the way that a PCP is structured (usually a low deposit, low monthly payments and a large balloon amount), you will probably only reach the point where you can give the car back a few months before the end of the end of the agreement anyway. So it’s great if you hit trouble three months before the end of the agreement, but no use whatsoever if you’re only a few months in (or even a couple of years, in many cases).
You can voluntarily terminate your agreement at any time, but if you haven’t reached your 50% point then you will have to pay the difference to make it up. For most car owners with a PCP, that’s still a negative equity position and not really any better than selling the car with the permission of the finance company and settling the full amount.
So does that mean I’m screwed?
Unfortunately, there’s not usually a good outcome if you want/need to change your car before the end of the specified term. The reality is that you will usually have to find several thousand pounds to settle a PCP early. This is the nature of a secured loan on a depreciating asset, where you’re paying for a product you don’t own and is losing value faster than you’re paying it off.
You should contact the finance company and discuss your situation. If you are suffering from genuine financial hardship, they may be able to offer alternative payment terms to help you work through your problems. You will probably end up paying more in the long run, but you may get some short-term relief. However, don’t pin your hopes on the finance company being too helpful – their first response will always be to insist that you pay what you owe.
If you are wanting to settle your PCP early because you’re trying to buy another car, you may find that there are deals on offer that will help you with your negative equity. Be very careful here, as you may be simply setting yourself up for more problems on your next car, and you could find yourself back in the same position (or an even worse position) very quickly.
If you genuinely can’t settle your debt, you may have to accept voluntary surrender. This is a very different thing to voluntary termination. You give back the car but still owe whatever is left to pay (and the finance company will add on extra costs for collecting and disposing of the vehicle). This is pretty much a worst-case scenario, as the finance company will still be chasing you for money even though you’ve already given back the car.
If you are suffering financial hardship as a result of the coronavirus pandemic, there is help and guidance available. Your finance company should offer you a three-month payment deferral on your car finance agreement. Before taking it, however, you should read our exclusive analysis of this payment holiday initiative to decide if it is right for you.
Should I settle a PCP early or keep it until the end?
A PCP agreement is set out to be financially optimal to run it all the way to the end of the agreement. The reality is that most times, you’ll have to pay out a substantial sum of negative equity to settle a PCP early.
Whether or not it is worth paying to settle the finance depends on how important the need is to change your car or get rid of it.
Circumstances change, and the cost of paying to get rid of the car now may be better than paying more to keep it for the rest of the agreement. Alternatively, your car may no longer be suitable for your needs, and the cost to change may be worth it to you.
Is it simply impatience that makes you want to change your car early? In that case, understand that you’ll be paying a high price to settle your PCP early instead of finishing it as scheduled.
The dealer who sold you your car will often contact you several months (or even a year) before your PCP is due to finish. They will try to entice you to buy a new car ahead of schedule with an early upgrade offer. Sometimes these offers are advantageous. But usually, they’re a bit of smoke and mirrors, and not really worth it.
You should plan your purchase carefully to make sure you are not destined for an expensive problem in a few years’ time.
If you’d like to hear more tips and advice on car finance and the coronavirus pandemic, have a listen to my podcast on BBC Radio 4’s Money Box programme.
This article was originally written in June 2014 and was most recently updated in May 2020. Latest changes include re-writing the section about negative equity and depreciation, as well as information boxes regarding information about our coronavirus-related car finance advice.