PCP finance explained – what is PCP and how does it work?
PCP finance deals are a popular way of getting into a new car. We cover everything you need to know
Purchasing a new or used car using finance is proving more and more popular, with the days of outright cash buying seen as a thing of the past. One popular finance method is Personal Contract Purchase (PCP), an agreement with typically low monthly payments and the option to buy the car outright at the end of the term.
There are other financing options that exist alongside PCP, including Hire Purchase (HP) and Personal Contract Hire (PCH), but it can be hard to discern the differences between them. We will be taking a detailed look at the fine print of PCP finance, what sets it apart from other methods and whether it is the right finance option for you.
Personal Contract Purchase (PCP) vs Hire Purchase (HP), Personal Contract Hire
The three most popular methods of financing a car purchase are Hire Purchase (HP), Personal Contract Hire (PCH) and Personal Contract Purchase (PCP). PCP differs mostly to PCH, as PCH is simply a long-term lease that isn’t designed for you to purchase the car at the end of your agreement. PCP also differs from HP in a few ways.
In a PCP deal, you pay off a portion of the car’s value in low monthly payments. This leaves the remaining portion of the car’s value to pay at the end of the agreement, known as a ‘balloon’ payment, which you can choose to pay if you want to own the car. Alternatively, if you don’t want to keep the car, you can choose not to pay the balloon payment and walk away. In an HP deal, the balloon payment is taken at the start of the term, and you will own the car once you pay off the last monthly instalment – these deals usually last for three to four years.
Saving thousands of pounds to buy a new car outright is an impossibility for most people, and PCP deals offer a good balance between low monthly payments, while leaving the option to buy the car outright at the end without any of the obligation. It’s a more realistic solution for many buyers – there are many great PCP deals to be had and you might even have some room to negotiate on prices.
If you’ve decided that a car finance agreement is the right option for you, it’s understandable that you might feel daunted by the large amount of information there is to take in. We’ve put together a detailed guide to how PCP works, including some example PCP finance plans below.
We'll start from the very beginning, explaining what PCP is and how it works. Then we'll delve into what kind of PCP scheme to choose, how the terms should look, what happens during and after the agreement and we've also provided plenty of examples to help you understand it all better.
What is PCP finance?
PCP finance is broken down into three key elements:
- An upfront deposit
- An agreed number of monthly payments
- An optional final ‘balloon’ payment
PCP's key features are a 'front-end' customer deposit and an optional final 'balloon' payment. These familiar terms describe lump payments made by the customer at the beginning and end of the term, the result being monthly payments are typically far lower than those of a Hire Purchase (HP) arrangement on a car of the same value. An HP deal consists of an upfront deposit and then a set number of payments. There’s no large final payment, because that’s been absorbed in your monthly costs.
The major benefit of PCP deals is their flexibility. Whilst a common deposit is 10% of the car’s value, this can be changed depending on how much you are able to pay upfront or how much you want to pay per month. For those who can’t stretch to an upfront deposit, it’s possible to find no-deposit deals, although be aware that this will result in higher monthly payments.
At the end of the agreement, you have a choice of options too. Paying the balloon payment means the car is yours to keep. Alternatively, you can hand the car back and not pay any final payment. The other option is to use any ‘equity’ you’ve built up as a deposit on a new car (we’ll explain this part later).
PCP was already popular in North America when Ford introduced it to the UK with its 'Options' plan in 1992. It immediately proved popular and other mainstream manufacturers were quick to follow suit with PCP products of their own. Today, the majority of franchised main dealers offer PCP deals on new cars, either underwritten by the manufacturer's own financial division or a third-party finance company.
Such is their popularity that PCP deals are also common for nearly-new and used cars, but oddly these can sometimes cost more each month than PCP for a new car. This is because manufacturers are keen to promote new car sales, so they will usually offer tempting deposit contributions and low-rate finance deals to secure buyers. This isn’t always the case, of course. To work out what you can afford, always make sure you shop around and ask for a personalised PCP quote.
How does PCP work?
The simplicity of a PCP scheme is what makes it so appealing. You visit the dealer or online retailer, choose a car, pay the deposit, agree on a monthly payment and interest rate, sign the papers and drive away. Easy as that!
The process outlined above pretty much mirrors what happens under a Hire Purchase agreement. You take the cost of the car, subtract a deposit, add some interest and then divide the whole by the number of payments. The details of a PCP agreement are a little more technical, though, and take some understanding.
With a PCP agreement, you’re not actually paying towards the ‘new price’ of the car. All cars naturally lose value over time, a process referred to as depreciation. The payments you make under a PCP agreement essentially cover the pre-agreed amount of depreciation experienced during the agreement.
When a dealer prepares a three-year PCP agreement, they use a prediction of what the car will be worth in three years’ time. This estimate is provided by the finance house underwriting the agreement and is referred to as a Guaranteed Minimum Future Value, or GMFV.
During the course of your PCP agreement, you’ll be paying off the difference between your car’s new price and the GMFV figure.
It’s because the future value of the car is taken into account that PCP figures can look so attractive. Let’s look at a simplified example without taking into account the fees and interest that most PCP schemes will encompass.
- A new car costs £25,000
- The GMFV after three years is £15,000
- Over three years, you need to cover £10,000
- You pay a deposit of £1,000
- You’ll pay the remaining £9,000 over 36 monthly payments of £250
Choosing the right PCP scheme for you
When setting up a PCP agreement, you need to decide on the length of the agreement, the size of your deposit and the number of miles you’ll cover a year. You can shop around to get the best interest rate, but the GMFV is likely to be the same wherever you go.
The GMFV will be affected by the length of the finance agreement and the car’s mileage at the end of the term. The older the car and the higher the mileage, the less it’ll be worth.
Before you’ve signed a PCP scheme, be certain that you want to complete the full length of the agreement. If you’re someone who will likely change their car after two years, don’t finance it over three or four. That’s because the GMFV will be calculated based on a model that follows the depreciation curve your car is predicted to follow. Depreciation is most severe in years one and two, but starts to level out by the third year.
That means if you want to change your car two years into a three-year agreement, it’s unlikely you’ll have paid enough to cover its depreciation – meaning you’ll have to cover the shortfall.
If you do wish to leave your PCP agreement early and hand back the car, you are legally entitled to voluntary termination. So long as you have already paid back 50% of the total amount payable, you won’t have to pay any additional fees. But be warned, this total amount includes interest as well as the final ‘balloon’ payment. This can end up being a large sum of money that many people will not have paid back until near the end of their agreement. In this case, you would have to pay the outstanding amount to make up the 50%.
Getting your monthly PCP payments right
When financing a car, it’s tempting to make the monthly payments as low as possible. This can be achieved by paying a large initial deposit, which is a popular course of action amongst those with savings or inheritances to hand – but it’s not always the best approach.
Take the example from earlier, where we financed £10,000. While a 10% deposit is normal, there are different ways you could split that amount in terms of deposit against monthly payments. For example:
- A 4% deposit of £1,000 and 36 monthly payments of £250 makes £10,000 in total
- A 16% deposit of £4,000 and 36 monthly payments of £167 makes £10,000 in total
No matter how the split is decided, you’re still paying the same over 36 months.
Opting for a larger monthly payment can give you a little flexibility if your situation should change. If, in nine months, your current car becomes unsuitable for your needs and you’re forced to buy a different one, you’ll first have to pay off the remaining finance or ‘settlement figure’ you owe.
What happens at the end of a PCP?
During the PCP, you don’t own the car. Your V5C document may say that you’re the registered keeper, but the finance company maintains property rights. It’s not until the end of the contract that you have the opportunity to buy the car outright. This is one of the three options you have when your PCP contract elapses.
PCP deals are usually taken out over between two to four years. At the end of the contract, your three options are:
- Pay the ‘balloon’ payment to own the car
- Hand the car back and walk away, paying nothing and owning nothing
- If the car is worth more than the GMFV (i.e, you have paid more than the car has lost in value), you can use this difference towards the deposit on a new car, possibly on another PCP deal
Dealers usually set the Guaranteed Minimum Future Value (GMFV) as less than the car’s actual value at the end of the contract, encouraging customers to take the third of these options.
However, some PCP deals have higher GMFVs to keep the monthly repayments attractively low. This could lead to you having less money for the next deposit contribution than you thought.
If you love your current car but can’t pay the GMFV in one go, some lenders will let you refinance it over several more years. Because of the age of the car at that point, you’ll be offered a Hire Purchase deal, which could make your monthly payments higher than the original deal. Bear in mind that you’ll be paying your car off over a long period of time - it’ll only be losing value and you’ll have paid more interest than if you’d have taken out a HP agreement at the start.
36-month PCP worked example
Let’s refer to our example of a car costing £25,000 and assume, for simplicity’s sake, you’ve managed to get an interest-free PCP deal. Here’s how the costs break down.
- £2,500 deposit (decided by you, but 10% of the car’s new value is common)
- A GMFV of £15,000
- £7,500 finance, covered by your monthly repayments; £208 a month over three years without interest
- £15,000 optional GMFV balloon payment
After three years, if your car is worth less than the GMFV, you won’t be left out of pocket. As its name suggests, the finance company has guaranteed that £15,000 value – if it’s worth less, the finance company will absorb that cost.
If the car is worth more than the GMFV, meaning you have paid back more than the car has lost in value, you can contribute the extra you’ve paid towards the deposit on a new finance deal for a new car. Unfortunately, you’re not allowed to take that extra cash and give back the car.
Now, let’s say that the car costs £25,000, but the GMFV has been set at £17,000. The deal may look like this:
- £1,000 deposit (4%)
- A GMFV of £17,000
- £8,000 loan, with monthly repayments of £222 over three years
- £17,000 GMFV balloon payment
The lower deposit and monthly repayments may look more attractive over the contract length, but at the end of the deal, let’s assume the car is worth £18,000, not £17,000 as predicted. If you want to own the car outright you’ll have to pay more than the previous example, or, if you want to use this excess to go towards a new PCP deposit, you’ll only have £1,000.
Note that at no point have we called this difference between the car’s worth and the GMFV ‘equity’ – although it’s often thought of in that way. Instead of being equity, the difference is actually money you’ve generated via the monthly repayments.
What are my commitments with a PCP agreement?
Like any contract, a PCP agreement comes with certain stipulations. When taking out a PCP deal, you’re typically bound to:
- Service the car according to the manufacturer’s recommendations
- Keep the car in good condition
- Not exceed a specified mileage over the course of the contract
- Take out a fully comprehensive insurance policy
Exceeding the mileage limit is allowed but will incur an additional charge. This could be between 5p and 10p a mile, which can quickly add up. Doing 1,000 excess miles at 10p a mile would cost £100, for example. PCP contracts are also realistic about what constitutes ‘good condition’: the car doesn’t have to be showroom-perfect, but a massive dent in the door will cost you.
Many dealers provide the option of taking out insurance when you’re agreeing to the contract. This can be expensive and likely won’t be the best deal, so shop around other insurance providers.
It’s also worth investing in GAP insurance to protect yourself financially if the car is written off during the course of the PCP agreement. Again, these policies are often cheaper from third-party companies.
What are the advantages of PCP deals?
- PCP deals usually come with lower deposits and lower monthly repayments than traditional HP agreements, meaning you can get a more expensive car for less money upfront and less each month
- People also like the idea that, at the end of a PCP agreement, the GMFV is often less than the car’s value. This means you can potentially drive away in a new car every three years or so, without having to come up with a full deposit
- Like most PCP agreements, most new-car warranties run for three years. This means that if you switch cars when the PCP deal expires, you’ll always be covered by the protection offered by a manufacturer warranty
- Another advantage is competition between carmakers and their financial branches is fierce. Many manufacturers offer deposit contributions, guaranteed trade-in values (useful if you’re upgrading from an elderly car) and even 0% interest on PCP deals, meaning there are lots of opportunities to save money if you shop around
What are the disadvantages of PCP deals?
- For some, the idea of making monthly repayments without actually receiving a tangible asset at the end of the contract means PCP deals are unappealing. Others feel uncomfortable with the large GMFV ‘balloon’ payment hovering over their heads for the duration of the agreement. If you recognise yourself here, investigate a hire purchase agreement. You may be faced with higher monthly payments and a higher deposit, but, once the final monthly payment is made, the car will be yours
- High GMFV values can mean you have less money to go towards the deposit on a new car than you might hope at the end of a PCP agreement. While it can be sensible to use the difference between the car’s value and the GMFV as the deposit on a new PCP deal, there can be a sense of feeling committed to doing this
- Another disadvantage of PCP deals is that it’s not generally easy to switch brands and take any ‘equity’ accrued to another carmaker
- Also consider that ‘Manufacturer Deposit Contributions’ are sometimes subsidised by the manufacturer. In lieu of a discount on the cost of the car, the manufacturer might contribute money towards your deposit, effectively reducing your monthly payment. This contribution may not be available the next time you buy a car, and your monthly payment for an equivalent car can swell without it
- Finally, it’s vital any PCP you enter into truly reflects your likely circumstances. When entering into a contract, remember that it has been designed for a specific term. If you’re likely to change your car yearly, don’t enter into a contract where payment continues for several years. A subscription service might be better if you want to switch cars regularly
For more car buying advice, read our guide to the 20 car buying secrets that dealers don't want you to know.
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