What is depreciation?

It's one of the most important elements when choosing a car, and it's so often overlooked. But what is depreciation?

Matt Rigby
Jun 27, 2018

Depreciation is one of the most important factors to consider when calculating the overall costs of car ownership. It is the amount of money a car will lose in value over time.

It is used to calculate most car finance payments. If you're buying your car outright, it is most important to you when you come to change your car, as it is the difference in value between when you acquired the car and when you come to change it.

Most consumer goods – whether TVs, computers or lawnmowers – are affected by depreciation; they will generally be worth significantly less as a used example than they were when brand new. The reason that vehicle depreciation is so significant is that the initial cost of a car is much higher than of most consumer goods, so the amount of money lost in depreciation will be greater. And, unlike many other consumer goods, cars tend to be sold and resold multiple times during their service life.

Minimising the effects of depreciation is one of the most important considerations for any car buyer – no matter if you are purchasing a new or used car, paying for it outright or taking out finance to fund your car.

New car depreciation

In the vast majority of cases, as soon as a car is registered, it will lose a significant chunk of value – in some cases up to 20% of its new price.

This rapid initial depreciation tends to slow down over time, but over the course of the first three years of its life a car can easily lose more than 50% of its value . After this, the rate of depreciation will slow down.

Buying a nearly-new car  can help to avoid the initial large loss in value, potentially saving thousands of pounds, depending on what you are buying.

The amount of money a given car will lose can vary wildly from make to make and from model to model, depending on several factors – such as how much they cost to buy in the first place, how desirable a particular model is, and how reliable a car is likely to be. The biggest-depreciating cars can lose three-quarters of their new value over the course of three years, while the cars that keep their value best can be hold on to over 70% of their new sale price when they reach three years old.

It’s important to note, too, that how much a car will depreciate depends on how many miles it covers, and what sort of condition it is in. A three-year-old car with low miles and in near-perfect condition can be worth significantly more than an identical model with a high mileage or in poor condition.

 

Used car depreciation

While the depreciation that affects new cars can be a significant cost over the course of your ownership of a car, and quite a challenge to minimise, the effects of depreciation on a used car can offer significant savings.

Low mileage cars that are just a few months old – such as models used as sales demonstrators by dealers – can offer substantial savings over the cost of a brand new car. Similarly, if you pick the right car, you can find a real bargain if you pick up a well looked-after example of a heavily-depreciating model.

However, heavy depreciation still affects finance repayments, and so it can sometimes be cheaper to get a more expensive car that loses value slowly.

 

What depreciation means for finance payments

A car's depreciation rate is used as the basis of two of the most popular finance agreements:

Personal Contract Purchase (PCP)

A car's depreciation rate is used to work out the amount that it's likely to be worth at the end of your PCP agreement, based on an agreed mileage limit. This is known as its guaranteed future value.

The finance company will calculate how much your car is likely to lose in value during the course of your agreement.

Your monthly payments are calculated to cover the cost of this depreciation, taking into account interest payments and any deposit you may put down. You can reduce your monthly payments by getting a car that depreciates slowly.

At the end of a PCP deal, you can choose to pay the guaranteed future value to buy the car. Alternatively you have the option of handing the vehicle back and walking away. If the car ends up being worth more than the guaranteed future value, you can trade it in and use the difference towards a new car.

Personal Contract Hire (PCH or car leasing)

PCH finance, or leasing, is long-term car hire. Your finance company purchases the vehicle you want at the beginning of the agreement and then delivers it to you.

At the end of the agreement, the finance company takes the car back and it's then sold on. Your lease payments have made up the difference - the depreciation. The less value a car loses, the lower the lease payments can be.

 

Depreciation’s impact on ending your finance early

The initial large drop most new cars experience could affect you significantly if you need to end your finance agreement in the first year or two of ownership. This is because the car may be worth much less than you owe to the finance company at this point, as it will have set finance repayments based on a predicted future value.

Settling the finance could mean you need to sell the car with the agreement of your lender, and make up the difference in the amount owed with your own money, or with negative equity finance.

 

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