Payment holidays for drivers will help keep car industry motoring
Biggest threat comes from collapse of PCP repayment method if economy fails to recover, writes Alan Tovey
THE City watchdog has told lenders that they must offer payment holidays to people struggling with car loans because of the coronavirus crisis. This is good news for consumers, of course – but it is also good news for the automotive industry.
Sales of new cars soared following the financial crisis, largely driven by the growth of personal contract purchase (PCP) deals. They offered drivers the chance to get into new cars for lower monthly payments than traditional arrangements such as hire purchase (HP). Instead of financing the entire cost of a new vehicle, PCPS cover the cost of a car’s depreciation.
For example, a customer wants XY Motors’ £30,000 car, which will be worth £18,000 in three years. Instead of taking a loan to cover the whole amount, a PCP means they just have to pay for the depreciation.
On a standard three-year deal, with a relatively small deposit, say £2,000, this leaves £10,000 to be financed. This equates to monthly repayments of less than £300, even with interest of 5pc on the amount being financed.
At the end of the term, the customer has several choices. They can hand back the keys with no obligation as long as they have met contract terms such as servicing requirements and not exceeding the permitted mileage. Alternatively they can make a “balloon” payment for the value of the car and take ownership.
But the most popular option is to use equity built up in the car – such as by driving less miles meaning it is worth more than the expected value at the end of the term – and using this to begin the process all over again.
Today 90pc of new car sales are PCP deals. They have been great news for car makers, fuelling demand.
But PCPS require a constant churn of people rolling into new contracts, as well as a strong market for used cars, as vehicles coming off the deals enter the second-hand market.
As long as prices are high in the used-car market, then the value of vehicles coming off PCPS is also high. But a glut of second-hand cars means a three-year car coming off a PCP could be worth less in the market than was predicted when the deal was agreed.
For our XY Motors example, instead of being worth £18,000 after three years, if dealers’ forecourts are packed with too many unwanted cars, then it might only be worth £15,000, leaving the lender who financed the PCP facing a £3,000 loss. As millions of cars in the UK are sold each year via PCPS, a collapse in second-hand cars could cause the whole system to fail.
With coronavirus raising the prospect of cash-strapped motorists handing back cars they can no longer
‘Economic growth has gone for now. Unless it snaps back quickly, the system could take a hit.’
afford, one can see why the automotive sector welcomes the Financial Conduct Authority’s action.
However, the whole system is “very finely balanced” warns Prof David Bailey, a car industry expert from Birmingham University.
“PCPS have propped up the market for years and depend on no upsets so car companies can manage supply and demand,” he says. “But coronavirus’s impact is unprecedented.”
PCPS have been so successful that they have moved into the used-car market. About 30pc of deals now use them. “PCPS have kept champagne corks popping for years, but the question is how sustainable are they in the long run,” adds Bailey.
Three years ago the Bank of England gave a guarded thumbs-up to the car finance market in its financial stability report, which found it made up 29pc of the total consumer credit of £198bn. Of the £58bn of car finance, £24bn was held by the banks and £34bn by car manufacturers and dealers.
The report noted borrowers were 10 times more likely to default on consumer credit than mortgages. However, the Bank said its models would need used-car prices to fall almost a third to create problems, a drop requiring hundreds of thousands of people to hand back cars on PCPS.
Mark Carney, then Bank of England Governor, said that unlike many products bought on credit, “people need their cars in general” so were more likely to keep up repayments.
But in a Covid-19 afflicted world, things could change rapidly.
“The PCP model requires decent economic growth for people to be confident to buy, so new cars go out of dealerships’ doors and the secondhand market can absorb them,” says Bailey. “Economic growth has gone for now. Unless it snaps back quickly the system could take a hit.”
Without a strong economic rebound, the wheels might yet come off the car market.