The Financial Conduct Authority’s 2017/18 business plan said this about motor finance:

“We are concerned that there may be a lack of transparency, potential conflicts of interest and irresponsible lending in the motor finance industry. We will conduct an exploratory piece of work to identify who uses these products and assess the sales processes, whether the products cause harm and the due diligence that firms undertake before providing motor finance.”

According to the Finance and Leasing Association’s 2016 Annual Review, “The percentage of private new car registrations financed by FLA members in 2015 was 81.4%, up from 75.9% in 2014”.

Data available to FLA members showed that over the 12 months to March 2017, an average of 82% of new car sales were funded using Personal Contract Purchase (ahead of hire purchase, leasing, and auto loans).  In 2015, 984,000 new cars were financed by FLA members. Enorcd estimates that in 2016, around 800,000 consumers entered into PCPs.

The FCA took on responsibility for consumer credit regulation in April 2014. Since that time £40,725 million has been spent, using PCPs, on new cars. It doesn’t take a genius to work out that PCPs will be the FCA’s main focus.

The PCP combines elements borrowed from leasing, and hire purchase.  A customer buys a car for a variable deposit and a monthly fee. After the 2-4 year contract term expires, customers hand the car back, make a “balloon payment” and own the car outright, or put any equity they have in the car towards a new model. The monthly repayments are lower than for traditional hire purchase.

The balloon payment is also called the Guaranteed Minimum Future Value (GMFV) and is the finance provider’s estimate of the car’s value after depreciation, made at the beginning of the contract. If the car is worth less than this figure, based on fair wear and tear and staying within a pre-agreed mileage limit, the customer can hand back the car. If the mileage has been exceeded, there’s a fine to pay (somewhere between 7 and 14p per mile).

Alternatively, the customer enters into another PCP. Only the equity built up in monthly repayments, and a positive GMFV figure can be put toward the next car. For example if the car’s value at the end of the deal was £9,000 and the balloon payment was £8,000, the difference of £1,000 could be used towards the next car (so long as it’s via the same finance provider).

Speaking to the Telegraph in 2014, Mark Norman, market analyst from CAP Automotive said:

 “We’ve anecdotal evidence that customers have it inferred to them by the dealer that they will have equity left in the car when they more than likely won’t. Manufacturers doing this might be making a sale today but in three years’ time that customer may well not be able to afford another PCP and a new car sale will be lost.”

Enforcd reviewed a typical BMW finance offer:

BMW 118i 5-Door M Sport Sports Hatch. Four year (48 month) contract. 10,000 miles per year.

47 monthly payments £239
On the road cash price £24,650
Your deposit £4,109
Our deposit contribution £1,687.44
Total deposit £5,796.44
Total amount of credit £18,853.56
Optional final payment £9,828.13
Total amount payable £26,858.57
Rate of interest 3.9% Fixed

On the face of it, it’s a reasonable way to spread the cost of a new car. The customer puts up £4,109. Source of funds may be a credit card (soon transferred to a 0% deal), or a personal loan. The customer pays a total of £11,233 in monthly payments. If they give up the car at this point, they’ve paid £15,342 to drive 40,000 miles in a new car, for 4 years. At this point, it may or may not be cheaper to buy a four year old BMW 118i 5-Door M Sport Sports Hatch second hand. If it is, the customer hands the car back. If it isn’t, they buy the car (keeping it or selling it privately), or put the equity towards their next new BMW, retaining the difference.

The key problem is at the affordability assessment and product design level. Enforcd assumes that no one wakes up thinking that they want to spend £15k to not own a car at the end of it. In that case, PCP is a lending structure designed with the needs of car makers with a dealer network to support. The structure of the agreement creates two sales opportunities (the sale of a new car, and its second hand sale). In both cases the manufacturer gets paid and the dealer can upsell the customer to a new car, or have a second hand car with a single owner and 40,000 miles on the clock to sell. Also, the carmaker is probably financing the whole loan, collecting more interest than they’d receive on cash.

A 2017 Telegraph article included results from its mystery shopping, which tested affordability assessments (a key plank of CONC, the FCA’s consumer credit handbook chapter):

“A salesman at one firm encouraged a customer, who said he had £400 total monthly disposable income, to apply for a deal on a Volvo V40 with heated seats and metallic paint. At a cost of £397-a-month it would have left the customer with just £3 a month to live on. To buy the car outright would cost £22,800.

Another firm suggested a £372 per month deal on a “premium” Hyundai Santa Fey, which retails at £31,406, could be suitable.

The offers were subject to the shopper passing basic credit checks, but salesmen appeared confident that the deals were affordable.”

The finance industry has been here before. In 2005, the FSA took on responsibility for regulating General Insurance. Its Principles applied to sales of payment protection insurance from this date. As such, it was able to argue successfully before the High Court in 2011, that even though it took many years for it to articulate how PPI sales ought to have been conducted, nonetheless, this was reasonably foreseeable by reference to the Principles.

There are further similarities, other than new regulatory requirements, between PCP and PPI: an FCA thematic review in progress, three years’ worth of newspaper concern, rapid sales growth, and a distribution network of non-finance practitioners (the first PPI mis-selling fines were handed out to shopping catalogues and retailers).

The final twist might be the half rule (from the Consumer Credit Act 1974): in the event of financial difficulty, the customer can end the hire purchase (PCP) agreement by paying half the purchase price and returning the car. If they haven’t, or can’t pay half the price, then they will still be liable for the difference:

With a financial downturn inevitable, it remains to be seen how well car dealers explained the risks of ‘owning’ a car funded using a Personal Contract Purchase. The potential impact on industry is demonstrated by Dollar Financial UK (a high cost short term lender).  The FCA instructed a skilled person to conduct a review of its lending and collection practices. The review revealed that many customers were lent more than they could afford to repay.

Following discussions with the FCA, in October 2015 Dollar agreed to pay redress relating to loans taken out between 1 April 2014 and 30 April 2015 in respect of affordability issues. The agreed package (which also covered collections issues) consisted of a combination of cash refunds and balance write downs costing £15.4 million:

  • 65,000 customers would receive a cash refund.
  • 67,000 customers would have their current loan balance reduced.
  • 15,000 customers would receive both a cash refund and a reduction in their loan balance.

A downturn that crystallises the problems with PCP will also cause new car sales to fall. So the lending arms of large global car firms may well be hit with £500 Financial Ombudsman Service complaint fees about affordability assessments, followed by the bill for large redress schemes at the same time as their income plummets.