Last year, my good friend Colin went to buy a car in the UK. He went to a reputable dealer, browsed the available cars and eventually drove away with a new Audi A3.
When I asked him about it, he told me he’d taken out a finance option called Personal Contract Purchase (PCP). And when I pressed him on it, he couldn’t actually explain what PCP was or how it worked.
Colin isn’t alone either. In the UK, 88% of men and 75% of women can’t actually explain what PCP is or how it works. And yet PCP is still the most popular car finance option used by 75% of people buying new cars!
That’s super worrying as it means hundreds of thousands of people like Colin are signing long-term financial agreements without actually understanding them.
In this article, I’m going to try and fix that. I’ll discuss what a PCP contract is and how it works. Hopefully, by the end, you’ll be a bit more informed and able to make a more informed buying decision.
A PCP Deal Explained
PCP works by breaking down the value of a car into three parts: the initial deposit; the monthly payments; and the balloon payment. You pay each of the parts at different points in the contract.
Before you take receipt of the car, you pay the initial deposit. During the contract, you pay the monthly payments. And after the contract runs out, you have the option of paying the balloon payment to buy the car from the dealer.
Here is a quick example of a PCP contract in action.
Let’s say you want to buy a Ford Fiesta, which costs about £14,000 new. The first thing the dealer will do is calculate the balloon payment, which is based on the Guaranteed Minimum Future Value of the car. (That’s just a fancy way of saying how much the car will be worth at the end of the contract.)
Let’s say you’re looking at a three-year deal and the car will be worth £7,000 at the end of year three.
- Balloon Payment: £7,000
Next, you pick your deposit. A dealer will usually ask for a minimum deposit of 10% of the list price but it can be more or less depending on your negotiation. In this case, let’s say you put down £2,000.
- Deposit: £2,000
Finally, the dealer calculates your monthly payments. What’s left to play is really just the list price minus your deposit and the balloon payment. In this case, that leaves £5,000 you need to pay off during the contract, which is £138 per month.
- Monthly Payments: £138 per month
At the end of the three-year deal, you’ll have paid £7,000 to the dealer, leaving the remaining £7,000 as the optional balloon payment.
If you want to buy the car from the dealer, you pay the balloon payment. If you don’t want to buy the car, you hand it back and walk away.
That end-of-contract flexibility is one of the best things about PCP contracts and is actually what I’m going to talk about next.
End of Contract Options
As I mentioned earlier, you have a few different options at the end of a PCP contract. To be precise, you’ve got three.
First, you can buy the car from the dealer. All you have to do is pay the balloon payment and ownership officially transfers from the dealer to you. However, the balloon payment is usually quite large so customers often struggle to achieve this.
The good thing about PCP is that you’re making this final decision after a few years using the car. By this point you should know whether it’s a good long-term option.
Your second option is rolling your contract into a new one. Often, if you’ve looked after your car, it’ll be worth slightly more than the dealer thought it would be. In these scenarios, you’ll have some positive equity left in your car. While the dealer won’t pay that equity out in cash, you can often roll it into your next contract, allowing you to pay off a chunk of the deposit.
Your third and final option is to walk away. If you have decided the car isn’t right for you or you just want to get a new car, you can hand the keys back and walk away.
(About four in five people choose one of second two options — rolling the contract on or walking away. Just one in five people on a PCP contract actually end up buying the car.)
Unexpected Charges and Fees
Unfortunately, there are some unexpected costs associated with a PCP contract, which can bump up the price a fair bit.
First, you’ve got insurance. Since the car is technically always owned by the dealer, you’ve got to follow their rules on insurance. Most PCP contracts will require you to have fully comprehensive insurance and something called Guaranteed Asset Protection or GAP insurance. GAP insurance basically covers the difference between what the insurance company says your car is worth and what the dealer originally paid for it.
Second, you’ve got damage charges. While the dealer expects some a small amount of wear and tear, you have to keep your car in good shape and return it in saleable condition. If, at the end of your contract, you return a car with loads of dents, dings, scratches and cracks, it’s suddenly worth a lot less than the dealer expected it to be worth. Someone has to pay for those repairs and that someone is you.
Third and finally, excess mileage. Before you finalise your contract, you have to estimate how far you’ll drive each year. The dealer then uses that estimation to help calculate the value of your car after the contract.
If you drive more than your estimated mileage, the car is worth less and someone has to make up the difference in value. Again, that someone is you.