What is PCP finance? Personal contract purchase car finance explained

More than nine out of 10 new cars purchased in the UK are funded with car finance. PCP (Personal Contract Purchase) is the most popular type of finance, and it’s increasingly being offered for used car purchases, too. Watch our video above for a quick overview of how PCP finance works.

People are drawn to PCP deals because they offer fixed monthly payments that are lower than with traditional car loans, and give you the option of buying the car at the end - if you make the large optional final payment. However, if you don't want to buy the car, you can hand it back and start again in a new car. Keep reading to understand whether PCP works for you.

The deposit and monthly payments on a PCP deal essentially cover the value that the car is expected to lose during the contract term - the difference between the car's initial price and its predicted value at the end of the contract.

As a result, instalments for PCP finance are much lower than for an equivalent Hire Purchase (HP) deal with the same deposit and contract length, as HP monthly payments cover the whole value of the car and you automatically own it once you've made all those payments. Meanwhile, with PCP finance, you'd need to make the large optional final payment when the contract ends, if you want to take ownership.

Since the optional final payment can amount to as much as half, if not more, of the car’s value at the start of the contract, it’s worth having an idea of what you’re going to do at the end of the contract - before you sign on the dotted line.

PCP finance deals typically last between two and five years. At the end, you generally have three options:

1. Hand the car back with nothing more to pay (providing there's no damage to the car beyond fair wear and tear and you've stuck to the pre-agreed mileage limit).
2. Buy it outright by making the large optional final payment or by refinancing the remaining balance.
3. Trade it in if the car's value is higher than the remaining balance on the contract, and use the extra value (known as equity) as a deposit on a new car to lower its monthly payments.

What happens if I decide to hand the car back?

Should you hand the car back at the end of the contract, there are several factors that the finance company will consider, before the contract is complete. Firstly there’s the mileage allowance that you signed up to at the start. Secondly, is the state of the car and whether there is any damage to it. Go over the mileage allowance and cause any damage beyond fair wear and tear and you can expect to be charged for it.

Mileage limits for PCP finance typically start at around 5,000 miles per year and go up to around 30,000 miles. The higher the mileage allowance, the higher your monthly payments. However, be aware that if you go for a lower allowance to access lower payments and then exceed this limit and hand the car back at the end of the contract, you'll be charged anywhere from 3p to 70p for each mile over the agreed limit - depending on whether the car is a common hatchback or a very rare sports car.

Therefore, it's worth being realistic about the mileage limit you choose, because excess mileage charges could amount to thousands of pounds if you go way over what was agreed. Excess mileage charges typically cost notably more than simply going for a higher mileage contract in the first place, so it's worth trying to select an accurate mileage cap to begin with - or contacting the finance company to update your contract terms, if it looks like you're going to significantly exceed your agreed mileage cap.

Be aware of end-of-contract damage charges, too. If you hand back a car that's peppered with scratches and dents that go beyond the typical wear and tear you'd expect for the age of car, it's likely you'll be issued a charge for fixing the damage.

If you plan to buy the car by making the optional final payment, meanwhile, you will not be charged for the excess mileage or damage - because the car then becomes yours. However, this will still affect its value later on should you come to sell it, with high-mileage cars and poor-condition ones being worth less than low-mileage and good-condition ones.

How PCP finance works

1. You may need to pay a deposit, but many PCP deals don’t require one.
2. Choose the contract length (usually two to five years) and mileage allowance. Make set monthly payments.
3. At the end of the contract, you have three options:

• Return the car with nothing to pay - even if it's worth less than expected (provided it's in good condition and is below the mileage limit set at the start of the contract).
• Keep the car by paying a lump sum, known as the optional final payment (also referred to as the balloon payment or guaranteed minimum future value - GMFV). You can refinance to spread this cost.
• 'Trade in' the car for another one. If it's worth more than the optional final payment, then the difference can be put towards a deposit on another finance deal, helping to lower your next set of monthly payments.

Used car PCP finance

PCP is available on new or used cars typically up to around four or five years old. In both cases, finance incentives may be available, including deposit contribution discounts. Opting for used car PCP finance can be one of the simplest ways to slash your monthly payments, with the lower cash price of used models meaning you’re borrowing less money. 

PCP also involves smaller instalments than Hire Purchase would provide for the same car (assuming the same deposit, contract length, APR figure and availability of any deposit contributions), though you’ll pay more interest with PCP - as you’re paying off the balance more slowly.

Older cars are not normally available with PCP because it becomes difficult to predict their value at the end of the agreement, so the monthly instalments and optional final payment can't be calculated accurately. In these cases, Hire Purchase finance (HP) is usually offered, which spreads the total cost of a car across a series of fixed monthly payments. 

How do I make PCP finance more affordable?

PCP monthly payments are based on the difference between a car's price at the start of the agreement and its estimated value at the end (the optional final payment or Guaranteed Minimum Future Value).

This difference, minus the deposit, is divided into equal monthly payments and interest is added. In-demand cars that hold their value well tend to come with relatively low monthly payments because the difference is smaller, although the optional final payment is larger, should you choose to buy the car.

Low interest rates - especially 0% APR - play a big part in keeping costs low, particularly with PCP because you are charged interest throughout the contract on all of the outstanding debt.

This includes the large optional final payment, which racks up interest charges throughout the contract term - even though you're not paying it off in your monthly payments. Another factor to bear in mind is the availability of deposit contribution finance discounts, as these aren’t taken into account in the APR figure.

This means that it’s perfectly possible for one finance option with a high interest rate and a very large deposit contribution could prove cheaper overall than another one with a lower APR figure and a smaller/no deposit contribution. The best way to be sure which option offers you the best value, get like-for-like finance quotes, with the same finance type, contract length, deposit amount and mileage allowance.

A bigger initial deposit results in lower monthly payments and reduces your interest charges. Opting for a longer PCP deal (such as five years instead of three) will also cut your monthly payments, although you’ll pay more interest over the course of the agreement - as you’re borrowing money for longer - so in reality it's worse value.

If the car is worth more than the optional final payment at the end of the contract, you’re better off ‘trading in’ the car rather than simply handing it back.

This way, the extra value in the car over the outstanding finance balance can be put towards the deposit on your next car, reducing your next set of monthly payments.

Alternatively, if you had the cash available, you could make the optional final payment to buy the car and then sell it for its true value, leaving you with more money for your next car than if you had just handed it back and walked away.

PCP finance vs Hire Purchase (HP)

PCP is the most commonly used type of car finance for a number of reasons, one of them being that PCP deals often come with substantial discounts. Dealers and lenders regularly offer low interest rates and deposit contribution savings to entice people, so in most cases, PCP deals will cost you less per month than other forms of finance including bank loans.

That said, Hire Purchase is likely to be cheaper overall if you want to own a car outright. This is because the monthly payments are larger, meaning you're paying off the borrowing faster, reducing the cost of interest. With Hire Purchase, you own the car at the end, so if you plan to sell it in the near future, you’ll get less back for it if it suddenly loses value. This isn't a problem with PCP, where the final value is set from the start, so you know what you'd need to pay if you wanted to buy it at the end of the contract.

When deciding which type of finance is best for you, the best way to make up your mind is to get like-for-like quotes for the different finance options - with the same contract length, deposit amount and mileage allowance - to see which best suits your budget and needs.

PCP finance vs PCH leasing

PCH (Personal Contract Hire) or leasing may be the cheapest option for a brand new car if you know that you don’t want to own it. There’s no option to buy the car at the end of the contract, and it’s generally only offered with new cars, but it’s also one of the simplest formats because it’s effectively a long-term rental.

Bear in mind, however, that it's harder to end a lease deal early than it is with PCP or Hire Purchase - and you may be obliged to make all of the remaining payments even if you return the car - should you end the contract early. There's also no choice to buy the car as there is with PCP.

It should be relatively easy to compare different types of finance deals because you should be told the total amount that's payable over the course of the agreement. Bear in mind that with PCP this includes the optional final payment, which is only made if you plan to buy the car.

As a result, if you want to own the car, you can compare the total amount payable figure for PCP and HP options to see which offers you better value. If there are any deposit contribution discounts, make sure to ask the lender whether these have been taken into account in the total amount payable figures and deduct them from this amount if they haven't.

How are PCP finance payments calculated?

All of the payments in a PCP deal depend on the optional final payment - also known as the guaranteed minimum future value (GMFV). This is an estimate of how much the car will be worth at the end of the agreement and is based on industry data.

The deposit and monthly payments then cover the difference in value between the car's initial price and the optional final payment - also referred to as depreciation. You pay interest on all of the money that you borrow, though - including the optional final payment.

The fact the optional final payment is fixed means that you don't have to worry about the car losing more value than expected. If it's actually worth less than this estimate at the end of the agreement, then you can still walk away with nothing to pay (provided the car's in good condition and within the pre-agreed mileage limit).

Remember though, that the car is typically worth more than this final figure, giving you a safety net if the market drops. If the market stays stable, therefore, the car is likely to be worth a little more than the optional final payment - with the extra value being referred to as equity. If your car has equity in it, you can then 'trade it in' for another finance deal, with the equity being put towards the deposit on your next car, reducing your future monthly payments.

How does PCP finance trade-in work?

Instead of returning a car with equity in it and walking away, you can trade it in and drive away in a new model, making use of that extra value, putting it towards a new finance agreement. This can cover some or all of your deposit, so there may be no need to dip into your savings, though you'll have lower monthly payments if you do put down a larger deposit.

It's important to remember that this isn't free money that's appeared out of nowhere - you’re simply getting back some of the money you paid in monthly payments that were based on a very cautious estimate of your car's future value.

If you’re looking to finance another car, then trading in is often a good option, because you can free up any equity in your car, without having to make the optional final payment to buy it beforehand. Do bear in mind that having equity isn’t guaranteed, though.

A particular risk is an economic downturn, when demand for cars may reduce. This will lower the value of used cars, and may mean that your car is worth no more than the optional final payment. If that's the case, you'll have no equity in your car and if you haven't been saving a little towards the deposit on your next car, you're likely to find that the same car would cost you much more per month next time around, with no deposit. Therefore, it's always wise to put whatever money you can aside during the contract for your next deposit, just in case.

Can I trade in my car with a different seller?

Yes. Few sellers will want to miss out on your business. You can usually trade the car in with a different seller or manufacturer at the end of your PCP deal. They will ensure that the finance is settled, and you will be able to use any equity in the trade-in car as a deposit. They may even value the car more highly, giving you a bigger deposit for your next vehicle. For the best chance of this happening, it's worth keeping the car in the best condition you can and sticking to your mileage limit.

Can I end my PCP finance contract early?

Yes. Whether you want a different car or are looking to reduce your monthly payments, you can end your contract early by requesting a settlement fee from the finance company. Once this fee is paid, you should owe nothing more to the lender. If you have the cash, you can simply pay it off and you'll own the car.

That's not an option for many people, so it is possible to sell or part-exchange your PCP car with the agreement of your lender, who remains the owner of the car until the agreement is settled. This is normally arranged through a car retailer.

If you are near the end of the agreement, then your vehicle may be worth more than the settlement fee. In this case, most of the proceeds of the sale or part exchange will go to your lender. The remainder of the money will either come to you or be put towards your next car.

Should your vehicle be worth less than the settlement fee, then you'll need to pay the difference between the car's value and the amount owed to the lender. This can be done through your own funds if you have them. If you are part-exchanging the vehicle for another one, however, then you may be able to take out a negative equity loan. This will cover the cost of the new car, as well as the remainder of the settlement fee, which you'll repay in monthly instalments.

If you're struggling to make your monthly payments, other options are available. These differ from lender to lender, so it's worthwhile checking with them to see what they offer.

Voluntary Termination

You’re allowed to terminate your contract voluntarily once you’ve paid off half of what you owe (this means half of the total amount payable, including the optional final payment in the case of a PCP deal). Once you’ve done this, you can simply give the car back with nothing more to pay.

A word of warning, though: because the total amount owed includes interest, fees, and the optional final payment, you won’t get to this point until fairly late on in the agreement. In the case of cars that hold their value extremely well, you may not get to this stage before the end of the contract.

If you don’t want to wait this long, it is possible to use your voluntary termination rights by making a one-off payment that tops up however much you've paid to the 50% mark.

You can also repay your PCP agreement early. This typically saves you money in the long run on interest payments, but you’ll usually need to pay an additional fee that covers some of the interest that the finance company is missing out on.

What happens if a car on PCP is worth less than expected?

One of the biggest benefits of a PCP agreement is that it offers total protection against a sudden and unexpected drop in car values. Once you've made all of your monthly payments, then you can just hand the car back with nothing more to pay, even if it's worth thousands of pounds less than the pre-agreed optional final payment.

However, an unexpectedly low valuation will limit your options at the end of a PCP agreement. If the car is worth less than the optional final payment, then you won't be able to trade it in; you'll need to find the money for a deposit towards another car elsewhere, or opt for a no-deposit agreement and face higher monthly payments.

Buying the car also wouldn't make sense in this scenario as you'd have to make the optional final payment to buy it, and this amount would be more than the car is worth. In this situation, you'd be better off handing the car back and buying a similar model that's for sale for a lower price.

What happens if I crash a car on PCP finance?

One of the conditions of taking out a PCP agreement is usually that the car is covered by fully comprehensive insurance. This would ensure that any repairs are paid for.

If the car is written off, then the insurance company would normally pay out for the value of the car at the time. This would go to the finance company, which is the owner of the vehicle during the PCP term.

However, if the car has lost a lot of value soon after you bought it - which is typically the case with new vehicles - then it's likely to be worth less than the amount that you owe to the finance company. You would have to make this difference up, so you can take out guaranteed asset protection (GAP) insurance to pay for this.

If your car is less than a year old, then it may benefit from a brand new replacement cover, which is often included in insurance policies. This covers the cost of replacing your vehicle with a brand new example, which is likely to clear your debt. If the vehicle is older than this, you could still face a shortfall between the remaining balance on the finance and what your insurer could pay if you wrote off the car, or even if it were stolen. GAP insurance covers that difference, to make sure you don't face a huge bill to settle the finance, should anything happen.

What does GMFV mean?

The guaranteed minimum future value (GMFV) is a crucial part of every personal contract purchase (PCP) finance agreement. It determines how much your monthly payments are going to be, as well as the ultimate cost of keeping your vehicle.

It's the key to keeping PCP finance affordable and flexible for new and used cars, and making it simple to regularly change your vehicle.

The GMFV will also protect you against any unexpected fall in the value of your car: the finance company take the hit if the vehicle is worth less than anticipated at the end of the agreement.

What is a GMFV?

The Guaranteed Minimum Future value is an estimate of how much your car will be worth at the end of a PCP finance agreement. The figure is calculated at the start of the contract and your monthly payments are then based on the difference between the price of the car and its GMFV. At the end of the agreement, you'll have paid off the value lost by the car (depreciation). You can then choose to buy the car for the GMFV, or refinance it. Alternatively, return the vehicle with nothing more to pay.

The GMFV is also known as the balloon payment. It offers protection against a larger-than-expected fall in the value of your vehicle, because the lender guarantees the valuation. If the car is actually worth less at the end, you can still return it with nothing more to pay (apart from any mileage and damage penalties).

How GMFV payments are calculated

Lenders use industry price guides to estimate the value of your car at the end of a PCP agreement and this figure becomes the GMFV.

Your monthly payments are then calculated to cover the difference between the price of the car at the start and the GMFV, minus any deposit, so you only pay for the car's depreciation over the term - not the full price.

Choosing a vehicle that holds its value well will help to reduce your monhtly payments, as the GMFV will be proportionately higher. But because you defer more of the cost to the end of the agreement, interest cahrges will be higher.

Once the last monthly payment is made, the value of the car is normally similar to the amount you still owe (the GMFV). You can either make that final payment, or refinance it to keep the vehicle. You can also return the vehicle to settle the agreement.

The right decision will depend on your circumstances, as well as whether the car is worth more or less than the GMFV (see below).

Should I pay the GMFV at the end of a PCP?

You'll need to pay the GMFV if you want to keep you car, and this can be done with a lump sum cash payment, or by refinancing the value. This could be in the form of another PCP deal, or a Hire Purchase (HP) arrangement, which would automatically make you the car's owner once the final payment has been made. You could also take out a bank loan to cover the cost.

It's generally wise to get your car valued by a car retailer or buying group before making your decision because it may be worth less than the GMFV. If that's the case, returning the vehicle is often the best option, as your lender will take the financial loss. Instead of buying your car for the GMFV, you'll be able to buy a similar second-hand model for less.

When your car is worth more than the GMFV

You'll often find that your car is worth more than the GMFV at the end of a PCP deal because lenders err on the side of caution with their valuation estimates. 

If that's the case, then you may be best-off not returning the car, even if you don't want to keep it.

• A popular option is to part-exchange the car for another vehicle. The GMFV will be paid to the lender on your behalf by the car retailer and any remaining money can be put towards your next vehicle.
• You could make the GMFV payment then sell the car immediately for more than you paid, leaving a surplus amount. This isn't a profit, but some of your monthly payments that you can recoup.
• In most cases, you'll be able to sell the car with the agreement of your lender, without making the final payment. The proceeds will cover the GMFV that's owed to the lender and the surplus can be returned to you.

Lenders tend to be conservative when calculating the GMFV to reduce the risk of cars being worth less at the end. It does mean that you're frequently overpaying for the car because the monthly instalments usually add up to more than the depreciation. If you return the car, then that excess is pocketed by the lender rather than you.