Too much financial advice is poor or just plain wrong. Even when it is not wrong it is often mealy-mouthed. It shouldn’t be because the language used is important. The Guardian newspaper recently changed its house style recommendations. It no longer refers to Climate Change and instead calls the issue by its real name Climate Emergency. The language of financial advice needs to change similarly.
They will be no such mealy-mouthed treatment about financial matters like debt in this blog. Borrowing money for anything other than a mortgage or business investment is fucking crazy. And particularly at punitive interest rates. It is a surefire route to lifelong financial enslavement. Signing a loan agreement should be viewed more akin to the scene in Alien where Ripley scuttles the Nostromo. As soon as she starts the detonation process flashing warning lights and alarms start to sound, a voice of impending doom echos throughout the ship and a countdown to destruction begins. The only difference here the message should scream ‘YOU HAVE ENTERED A DEBT EMERGENCY! COUNTDOWN TO FINANCIAL DESTRUCTION HAS BEGAN’. Over and over, that is what should be ringing inside the head of someone about to sign a loan contract for something they do not need, or to borrow money ‘just to be able to get by’. Those warning sirens should only fade once all unnecessary debt is cleared and a financial safety net built up.
That is good financial advice.
And it becomes even more important to stress this when you are borrowing money to buy a rapidly depreciating asset like a car. If you are borrowing money to do this, not only are you spending all your spare cash on a car, you are spending more than all your spare cash! Think about that.
Consider now what you are doing when you sign a PCP (Personal Contract Purchase) plan for a new car. You are borrowing the money for the car (minus any deposit) at a high rate of interest to buy something whose value is falling like a stone. You borrow this money and the finance company calculates the interest and monthly payments assuming a certain residual value for the car at the end of the contract period. This is the Future Guaranteed Value (FGV). This lowers the monthly payments but increases the amount of interest you will end up paying and means the buyer has to find the cash for a large final balloon payment to take full ownership of the car. The FGV is usually quite conservative because the car dealership doesn’t want to be stuck with a car worth less than the FGV should the buyer opt to walk away at the end of the contract. So it is not even the dealer that is taking the risk of future residual values. And you are contractually required to maintain and repair the car or pay for any damage at contract end. You even have to pay if you go over the agreed mileage allowance. Everything is stacked in their favor.
The car manufacturers love these plans of course as they also encourage an endless upgrade cycle. Anyone daft enough to purchase a car with borrowed money is unlikely to have the cash available to pay the large balloon payment at the end. What usually happens is the dealer offers the difference between the real market value and the GFV as an extra deposit against a new car on another 2, 3, or 4-year PCP plan. Thereby securing another very profitable sale on finance (which is where all the real money is made). Or, in the event the customer wakes up from their consumer sucker dreamlike state and opts to hand the car back the dealership sells it on the forecourt for more than the GFV. Either way, they win. The car buyer then has to source a replacement car and so the cycle repeats.
This is madness!
You are borrowing money at interest to pay for the rapid depreciation of an asset during that period when it is at its heaviest. In an endless cycle. Until you die. Or you run out of money.
Let’s do the math.
On a 4-year plan, you might expect to lose 60% of the new price on resale (much more for certain cars so be careful). Now, let’s assume the car has a 16-year life. At the end of the contract, you will have paid 60% of the new car price and used only 25% of the utility of this vehicle (that is the share of its total useful life). If the next owner keeps it for 12 years before disposing of it, and we ignore any remaining residual value, they will have paid 40% of the new car price and gained 75% of the utility. The original owner will have paid 4.5 times more for each unit of utility from this vehicle. This is a very rough and ready calculation as we have not taken into account opportunity costs. That multiple increases the longer the car lasts, the greater the initial depreciation, and the more residual value the car retains after 16 years.
Let’s put some real numbers to this. Imagine these three scenarios.
Scenario 1
Buyer purchases a new car for £30,000 on 4-year PCP contract at 5.99% and does this three times over 12 years with each subsequent car increasing in price by 10% to account for car price inflation.
Scenario 2
Buyer purchases a similar car at 4 years old for £12,000 (40% of new car price) and sells at 8-years old for £4,800 using cash. They do this three times over 12 years with each subsequent car increasing in price by 10% to account for car price inflation. They keep the car at the end of the final cycle.
Scenario 3
Buyer purchases a similar car at 4 years old for £12,000 (40% of new car price) and keeps it 12 years by which time it is 16 years old.
Once we take into account the opportunity costs at 7%, the cost for each of these scenarios is £128,000, £63,000 and £25,000 respectively. In the first, most expensive scenario, the buyer would not even have a car to drive at the end without stumping up for the final balloon payment. In this case £14,500 taking the total to £142,500. In Scenario 2 the owner has an 8-year-old car, while in the final scenario the car is 16-years-old but should still be perfectly serviceable if it has only done 10,000 or so miles a year.
To anyone worried about running a 16-year-old car I suggest you must never have bought a quality Japanese car like Honda, Toyota, or Lexus. Although all of my local miles are done in an electric car (see How to drive a free electric car) the Toyota Verso I use for long-range stuff is 12-years-old and has 140,000 miles on the clock and still feels tight as a drum. And remember you would have first bought this car while still under warrantee in immaculate condition with full service history so no real risk. From there you would have looked after it. Quality cars cruise to 250,000 miles still with their original engine and gearbox if maintained properly. And when the savings are over nearly £120,000 as here, what is the worse thing that can happen? A replacement engine or gearbox is mere bagatelle compared with that saving. In my experience older cars cost less to service and maintain because you do not need to use an expensive franchise garage, and even when you do, most have special reduced rates for older cars to encourage the owners to continue to use the network. I have never paid for a body repair. Minor cosmetic body damage is simply ignored.
Yet despite the simple maths it is amazing the number of people who still argue PCP plans are the cheapest way to buy a car. I’ve even been told they believe it is cheaper than buying a car second-hand! How? Do these people not know how to use a spreadsheet or a calculator? It is, in fact, far and away the most expensive way to buy a car.
And any saving would continue to grow if invested. If you had done something similar for 20 years the saving when compounded at 7% would then be worth about £240,000 now. Run two large family cars like this and it would be £480,000 after 20 years, without including all the running costs. Buy more ridiculous cars like a Land Rover Discovery and small Porsche or similar and you would be looking at £1,000,000 after 20 years. That is your retirement gone! Just so you can count yourself as a foolish consumer sucker.
Don’t get me wrong. The Bullmeister likes PCP plans and thinks they are great for him. But only because it means an endless supply of immaculate second-hand cars available for him to buy. So, with that in mind, I want to say a special thank you to someone. Whoever you are and wherever you may be.
Thank you for buying a sensible Japanese car. Thank you for choosing it in a my favorite colour and carefully selecting all the options I like. Thank you for dealing with that awful new car salesmen on my behalf. He was a slimy guy, wasn’t he? The promises he made and the lies he told! Quite shocking. Thank you for looking after the car for me and getting those minor scratches sorted. But most of all thank you for giving it to me with a 60% discount. I’m just sorry I won’t be able to look after it as well as you have. I don’t know how you kept it so pristine from new as I never seem to be able to. It’s having kids that does that. And driving down narrow bramble strewn country lanes in Cornwall on the way to the beach. Finally, I wanted to thank you for delivering it to the car auctions for me. I’ll take the car from here if you don’t mind.
I’ll see you again in a few years time when I’ll need a slightly different car. Possibly a small camper van for my long retirement.
The Bullmeister