There has been a huge rise in the number of cars bought using some form of finance package in the UK in recent years. Motor industry figures suggest that more than 1 million vehicles were bought on credit in the past 12 months.
But consumer groups and financial industry watchdogs are becoming more and more concerned that the surge in motor finance has the potential to lead to serious problems in the future.
Earlier this year, City regulator the Financial Conduct Authority (FCA) said it was opening an investigation into the way vehicle credit packages were sold to see whether car companies and lenders were making sufficient checks on borrowers to ensure they could afford to make repayments, and also that they understood how the deals worked and the risks attached.
More recently, Bank of England governor Mark Carney has raised concerns that a general rise in personal debt could lead to serious economic problems in the event of a rise in interest rates or increase in the unemployment rate.
Why has motor finance become so popular?
One of the reasons so many people are signing up for vehicle credit is the introduction of a new type of finance called personal contract purchase or PCP. This makes new cars much more affordable to buy by allowing drivers to pay for them over a period of several years at relatively low rates of interest.
As well as PCP – see the explanation of how it works below – there has recently also been an increase in car leasing, which is simply a form of long-term rental.
Should you buy or lease your car?
How do these deals work?
PCP is essentially a slightly tweaked version of hire purchase: motorists pay a deposit and then make monthly payments on their vehicle over a period of, say, two or three years.
At the end of this period, they have the option of returning the car, perhaps in order to start a fresh PCP plan on a new vehicle. Alternatively, they can make a lump sum payment – known as a balloon payment – in order to own the car outright.
If the car is worth more than this balloon payment at the end of the deal, the driver will have a certain amount of equity: this can be used as part or all of a deposit on a new PCP deal if they wish.
Five things to do before a loan application.
What are the risks?
So why is there so much concern about the rise in car finance? The main worry is that many people who are borrowing money in this way might at some point in the near future be unable to meet their monthly repayments – perhaps because they lose their jobs, or because other forms of credit become more expensive due to a rise in interest rates. (Car finance deals themselves normally have interest rates fixed for the duration of the loan, so repayment levels should not change at any point.)
Any borrower who could no longer meet their monthly vehicle repayments would have to give the car back: provided the car was worth at least as much as the outstanding loan, they could walk away from the deal.
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But if the car's value had fallen below the balance remaining on the loan at that point, the borrower would be in negative equity. This means they would have to make up any shortfall out of their own pocket, or risk facing debt recovery action from the car finance company – a situation that no one wants to be in, and something to consider before choosing this option when buying a car.
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