Frugal Motoring – The PCP black hole

Sadly not an angel dust-fuelled night club.

Once upon a time you walked into greasy Tony’s car dealership, slapped down your hard saved cash, and walked out with a creaky Lada/ British Leyland motor with build quality as questionable as Katie Hopkins.

Now we walk into a car megamart warehouse to be met by bright young things in shiny suits and pleather brogues. If we feel we are worth it we walk into glass prisms of monochrome and steel to be fed posh coffee by bright young things in shiny suits and pleather brogues who tell us we are definitely worth it, sir.

The world of buying a car has changed a lot, and numerous products now cater to whim and desire to self-indulge. The current petrol on the bonfire of consumer car culture is PCP, or Personal Contract Purchase, sometimes confused with Personal Contract Leasinging which is a more traditional rental option.

What is PCP?

A very clever tool to sell cars.

PCP is essentially a loan on the depreciation on a car you ‘buy’. You don’t really own the car despite assurances to the contrary (although this is a whole other thorny area). You pay a deposit, then a monthly payment on the loan that finances the value the car loses in your use, then hand it back to the finance company at the end or buy it off them. Money Saving Expert says it better than I can (1):

It’s one of the more complex financial products available to help you buy a car, but it can be broken down into three main parts:

The deposit (usually around 10% of the car’s price).Dealers offering PCP finance will typically want around 10% of the car as a deposit. Some car manufacturers’ finance arms offer valuable ‘deposit contributions’ of £500-£2,000 or more if you’re buying a new car but only if you take their finance – eg, VW Finance offers £1,000. The larger the deposit, the less you’ll have to borrow.

The amount you borrow. The amount you’ll have to borrow is based on how much the finance company predicts the car will lose in value over the term of the deal (usually 24 or 36 months) minus the deposit you’ve put down. You’ll pay this amount off during the deal, plus interest. So you’re not paying off the full value of the car. Typical APRs are 4%-7%.

The balloon payment (a balancing payment you pay IF you want to own the car). Also often referred to as the Guaranteed Minimum Future Value (GMFV), this is how much the dealer expects your car to be worth after your finance deal ends. It’s agreed at the start of your deal. You don’t have to pay this, as you get a choice of what to do at the end of the deal. But it is the sum you’ll pay if you want to keep the car.

So far so clever, the difference to a more standard agreement such as Hire Purchase being that you are not paying for the whole of the vehicle, just the depreciation. Therefore the monthly payments are much lower. This, combined with various incentives such as the ‘scrappage scheme’ (hack-spit) have meant that new cars are available to people previously unable to afford them. Often with these contributions and incentives the cost of a new car is lower than a used car for monthly payments. A worked example from Carbuyer (2):

– A new car costs £25,000
– The GMFV after three years is £15,000
– Over three years, you need to cover £10,000
– Subtract the a deposit of £1,000
– You’ll pay the remaining £9,000 over 36 monthly payments of £250

And some from national car retailers:

As Graham Hill, director at the National Association of Commercial Finance Brokers, says (3):

“Drivers who might have been looking at hire purchase on a second-hand Ford Focus can find themselves paying less on PCP for a brand new BMW 1 Series or a Mercedes A-Class”

Which is where some of the warnings begin.

The cautions

PCP is a complex product often used to sell high value items to people who may not be as financially savvy. As a complex financial product, there are often T&C’s to be aware of. A recent survey by the CarGurus found 9 out of 10 people didn’t understand the small print of their PCP contract (4). Though there are many online guides to PCP, that same survey found although 91% of people thought they had a good grasp of car finance, only 47% knew what PCP meant (4, 5).

Two big stings are the condition the car is returned in, and the agreed mileage limit. The condition is a standard agreement that the car will be returned in good condition ready for sale at the end of the term. This is usually assessed by the finance company, and repairs charged at in-house rates. That parking ding can quickly becomes £hundreds to repair, with limited ability to contest. If you happen to crash the car, or it is seriously damaged, you have to buy out of the deal, usually with a penalty. For servicing, some PCP deals require you use the manufacturer/ sellers in house servicing department, placing you over a barrel.

The agreed mileage limit is another bit of small print worth looking at. In seeking a good GMFV most finance companies set low average mileage limits (5-10k common). Go over that and every additional mile can be charged, typically at 5-10p a mile (5). So that 5k extra a year costs you £500 at 10p/mile, but with some bombsite backstreet dealers charging 30-50p/mile (6). Going back to that CarGurus study, more than half of those surveyed didn’t know what the penalty charges were on their contract (4).

The Canary

Warning sounds are beginning to be made about PCP for two reasons. The first is a flashback to 2008’s grim figure, sub-prime lending. It is unclear how many loans made for PCP in the UK were sub-prime, that is to people who will probably default. The car finance industry states it to be around 3% (7), but given the demographic PCP is aimed at this seems low. Outside of those selling PCP, economists at the BOE have privately expressed concern (8). The sale of sub-prime auto loans in the US is already becoming big business (9).

The BOE’s concerns touch on some of my own. PCP leaves the lenders exposed in many ways. An economic downturn could mean a default on that PCP loan (10). The same economic downturn could knock value of second hand car values and residuals, therefore devaluing the asset. The value is highly dependent on the GFMV.

PCP is often sold as ‘this is the minimum it will be worth at the end, but if it’s worth more then the equity can be used on another car’. The issue I have with this is that values are estimated years in advance, while on the ground prices change with fashion, numbers sold and all the other factors that effect car residuals. If most cars are being bought on PCP, as the people who used to buy the cheap secondhand car now buy a new one on PCP, the demand and value drops off in the second handmarket. We’re already seeing that at the bottom end of the market, with a bumper crop of cheap serviceable vehicles. Additionally a car manufacturer may be the focus of a scandle (say relating to falsified emissions results), which knocks consumer trust and desire for the brand and knocks prices. Ultimately someone will be left holding the difference between the predicted value and the actual value; an overexposed lender or a broke consumer. We are beginning to see this, but the train is still coming down the tracks. Rant over.

The final caution is on the reason people buy PCP deals. Some argue they will save on tax or help the environment compared to their old car (false economies for the most part, and a sad endictment of our broken car tax system). Others want a reliable car that’s in warranty that functions as a white good and can just be used. Here the disconnect is new=reliable, which is a cognitive bias that’s not always the case. More on that another time.

TL:DR

PCP is good if:

You read the small print
Maintain the car impeccably
Do less than the mileage limit
Don’t mind an unfashionable, unflashy car
You can afford to buy out of the PCP if something untoward happens.

PCP is not as good if:

You don’t read the T&C’s
You do big mileages and work the car hard
You want a flashy fashionable car
You can only just about afford it

As with any purchase, a car on PCP is a personal choice. There are risks, but with discipline and sense it can work. Just not my cup of tea.

Next time on Frugal Motoring- Bangernomics

Have a great week,

The Fire Shrink

N.B. If you are thinking of getting a car on PCP, check out Ling’s Cars, if only for the WTF.

References:

Musing on… Mortgages, what’s your risk tolerance?

I’ve recently been thinking a lot about mortgages, because I’m getting a new one. At the same time I’ve been educating myself about investment risk tolerance (1,2). I’ve done lots of online questionnaire’s to evaluate mine, which broadly show I’m willing to tolerate a lot of risk; I’m youngish, can wait most storms out and have a background in a profession where I have to manage risk daily. I also have the capacity to tolerate that risk; I make a good, secure salary and I won’t be investing money I can’t afford to lose. That’s not the case for my mortgage though, the single last purchase/ cost I’ll probably ever make. A post last week on r/UKPersonalFinance got me thinking:

Considering a variable rate mortgage over fixing, for reasons of flexibility. Crazy? from UKPersonalFinance

Stick or twist?

Are you mad Shrink? You need to fix, fix, fix, before the rates go up. Everyone says they will: the BBC (3,4), Newspapers (5,6,7,8), lots of blogs (9,10).

Is what everyone was saying when I was looking last week. Except the rates didn’t go up. We had crappier than anticipated economic results, and the BoE said no (11). It cut it’s growth forecast and interest rates remained on hold at 0.5%.

Well they can’t stay that way!

No, they probably won’t. But they could do, pollsters and pundits have been off before. They said Lehman Brothers, Northern Rock etc were too big to fail. They said Brexit wouldn’t happen. Predicting the future is Mystic Meg’s domain.

Mark Carney – will the last one out please turn off the lights.

Opportunity cost

Four years ago MrsFIREShrink and I were looking at putting our hard-earned deposit down. As 20-something millenials we were pretty unusual to be in that position. We leveraged a 90% LTV on a do-er-upper in the area we both loved, worked and intended on staying in. In those pre-Brexit, pre-May/Corbyn, pre-economic flatline days everything pointed to fixing for as long as we could. 4.29% fixed for 5 years was the best we could manage. That was ok as when we bought we planned to renovate and stay there for 5-10 years.

Fast-forward four years and we’ve moved 150 miles for job opportunities we couldn’t pass up but never anticipated. Our old house is for sale, and we’re trying to port our mortgage to save paying our eye-watering (5%!) exit fee. We’ve learnt that long fixed rates have their downsides (12). We look at others fixing for 10 years, who have no plans to move, and think about their flexibility (13,14). Going back to those trackers *affix hindsight glasses* had we selected a three year tracker rather than fixing we would have saved thousands in interest. This time we’ve taken information from a number of different sources, and used online calculators to think about our best financial options (15). Cardinal rule learnt: Always consult multiple sources, references and opinions before purchasing.

Where’s the risk?

Why didn’t we go for a tracker 4 years ago? We wanted to minimise our risk to a rising base rate. Despite being tolerant of risk in work and in cash/ stock investments in the past, I’m not for my housing. I started to think about why, and where the risk lay:

LTV – How much you’re willing (or the bank is) to leverage your cash against future earnings.
Monthly repayment figure – How much you’ll be paying back a month, and if you can afford it.

The two are obviously inextricably linked. Our LTV has improved to 80%, which looks to be optimal for interest rate offers. Risks/ costs worth considering:

Under-leverage – borrow less, with LTV 60-80%, and pay less on interest due to better rates and lower value. Buy a smaller property, but risk missing out on the extra equity caused by a potential increase in house prices.
Over-leverage – borrow more, with LTV 80-95%, and pay more interest due to higher rates. Buy a larger property, put more money in monthly, so more equity in the long run. Greater exposure if there is a house price falls resulting in more negative equity.

The tolerance for this definitely varies amongst my friends and acquaintances. The common theme amongst blogs I’ve read has been to leverage to your max, 90% at least, as long as you have a good duration (25 years+) of work-life human capital left. This seems to be driven by the view that property remains a good long-term investment option. Monevator does an excellent piece on this, although as it’s 2012 it’s a bit out of date (16). Just look at the long term trends below to get the picture:

Anecdotal evidence; I have a close friend who bought on a 85% LTV five years ago. He bought a property in an up-and-coming commuter belt, and the house value increased by about 25% (good on him). He took this and leveraged at 90% LTV on a thumping great Barratt executive home (le sigh), so in his early-30s is sat in a half-million pound house. He’s willing to tolerate the exposure because it’s their dream home and they intend to stay there 10+ years.

Historic Value

Digging a bit deeper into those trends to understand whether now is a good time to go max-LTV is difficult. The question; Have property prices always been a good investment? Could be a whole separate post in itself, but suffice to say it’s difficult to answer. Most property prior to the post-war housing boom was owned by landlords and rented out (are we heading back that way?). The British obsession with owning your own home is a new one. UK house price index data only reliably starts in the 1950s, but this LSE blog looks at land prices going back to 1892 (which helpfully are no longer published) (17).

To unpick this data note that the value of the home is made up of the value of the structure and the value of the land combined. This blog by James Gleeson summarises dis-aggregating house price value (18). From it I take this graph:

So, we see that the value of the structure increased slightly once inflation-adjusted, but residual values, i.e. that value of the land, is the source of most of the increase. This is also visible in the price of undeveloped land. Review the historic trends from the former LSE graph and we see that the increase in value is a modern phenomenon, and the long-term investment strategy of property is not so long term.

Short-term LTV Outlook

Again, another whole post in itself. In 2016 the UK Value Investor reckoned that UK house price forecasts weren’t looking good (19). Two years on and the market, as discussed in recent Full English Accompaniments, looks to be stodgy. Back then, UK Value Investor reckoned that house prices were in a bubble and due a crash. This was based on price to earning ratio data:

From UK Value Investor (19)

“Here’s a quick description of what that chart shows:

The black line – The average house price in each year
The red zone – Where the average house price would have been if houses were historically expensive, i.e. if the PE ratio had been between 5.5 and 6
The yellow zone – Where the average house price would have been if houses were at historically average valuations, i.e. if the PE ratio was between 3.8 and 4.5
The green zone – Where the average house price would have been if houses were cheap, i.e. if the PE ratio had been between 3 and 3.3″

The whole article is worth a read if you haven’t before. John predicts:

Expected capital gains from UK housing are zero over the next ten years

Which two years on looks pretty fair. His assumptions hold that house prices won’t crash, but will stay relatively flat while wages catch up. Worth considering if you’re buying now expecting a 10-20% increase in the value of your holding. Why waffle about this – it nullifies one of the arguments for a 95% LTV.

2. Monthly Repayment Figure

Back to our original list and the monthly repayment figure. A function of mortgage duration, principal sum and interest rate. I’m not going to go into duration so much, as this appears to be more a personal choice and dependent on how much human capital you have left. Opting to pay a short duration means more/ month, a long duration = less. People modulate their monthly repayment on big houses with high LTVs by going longer on their duration. The risk here is about what % of your earnings you’re going to be spending on your mortgage. Lenders set their affordability calculators on earnings, up to 4.5x, but this has got stricter. There have been concerns that borrowers who were previously approved will now struggle to remortgage due to the affordability rules (20, 21, 22).

The traditional model argues to aim for 35% of your pretax income to go on your mortgage, 45% at a push (23). Dave Ramsey advocates a conservative 25% of take-home (24). UK-wide this is on a downward trend, with Halifax reporting it’s dipped to around 29% in 2017/18, but with massive regional variability (25, 26). This has a complex interplay with affordability and price-earning ratio.

Bottom line – you don’t want to be paying so much on a mortgage you can’t afford other day to day activities. Money Advice Service and Money Saving Expert have good tools to work this out (15,27). The balance between fixing or tracking affects interest rate. Generally go for a tracker and it’ll be closer to the BoE base rate, go for a fixed rate and you’ll pay some percentage for the choice. Money Saving Expert also includes tools to compare trackers, or calculate if paying out of a fixed rate mortgage could be better value (28). People are fixing to avoid a base rate rise, and there’s various calculators available to help with this too, allowing you to calculate how much extra you would pay (27,29,30). The risk if you don’t fix – the BoE base rate skyrockets and repayments become un-affordable.

Anecdotal evidence; I have a colleague who’s a bit of a flash git. At 28-29, he owns 3 properties (from a standing start) and drives a new LR Discovery (on PCP/ lease). He achieved this by buying a small property straight out of university, sub-letting rooms, using the cash created for a second BTL property, and then leveraging that for a flat. All on about 80% LTVs. He works full time 48 hours a week in the medical profession, then does another 20 hours on top overtime to pay his mortgages. Just thinking about it gives me the collywobbles.

What have I learnt?

My risk tolerance for my mortgage is substantially lower than for investments. Our LTV is now 80%, we’ve opted for a shorter (2 year) fixed rate on our extension while our other fixed rate runs out, and combined these make up 39% of our take-home income. Once burnt, twice shy. We’re hoping to fix next year on the other larger principal, and that rates remain low. This seems likely looking at conditioning paths (31). Even if it rises to the long run UK average of 5-6% we’re comfortable. In face we’ve calculated that we can tolerate up to a 10% BoE base rate and still be ok. Those would be days of property price collapse, repossessions, defaulting and as Ermine over at Simply Living in Somerset teaches us the hooded figure of negative equity (32,33). We’re not at the 15% of the the mid-’80s, and it seems unlikely we will be any time soon, but my tolerance for the chance of losing my home is minimal (34,35). But if you have the stomach and the wallet for it, then maybe a tracker is a decent current option. Ultimately I’ve learnt I’m not willing to gamble my home or my family, and I’m not so gung ho after all.