Contract purchase is a way of getting a vehicle on finance but deferring part of the repayments until the end of the finance agreement.

The finance agreement is usually set up with the intention that ownership of the vehicle will eventually pass from the finance company to the buyer, principally to avoid the tax drawbacks of contract hire or leasing for vehicles with higher CO2 outputs.

In typical contract purchase arrangements the buyer is hire purchasing the vehicle, i.e. hiring it for a period of time with a view to purchasing it once an agreed number of payments or an agreed amount has been paid to the finance company.

The buyer will usually have an option to acquire the vehicle at the end of the contract upon payment of the final balance of the purchase price (the 'settlement value').

There may also be a 'sales agency' agreement with the finance company for the finance company to sell the vehicle on behalf of the buyer for a fixed fee at the end of the contract, or for the finance company to repurchase the vehicle for an agreed amount (a 'minimum guaranteed future value').

The contract may also allow the buyer to simply return the vehicle to the finance company at the end of the agreement (though this may have implications for VAT under new rules being proposed at the time of publication - check back here for more information).

What's in Contract Purchase Payments?

Typically the finance company will source the vehicle and dispose of it at the end of the contract. In addition, the finance company must fund the purchase as well. To cover these costs the finance repayments comprise:

• Depreciation
• Interest Charges
• The finance company's profit margin (which might be just the interest charges)
• Maintenance (Optional)

The finance company may include the Vehicle Excise Duty or 'tax disc' renewal each year as a part of an optional service or maintenance contract.

Because the purchaser pays only for depreciation during the period of the finance agreement (the 'term'), as each monthly instalment is paid the payment reduces the outstanding amount financed at a much slower rate than in 'fully amortised' finance such as hire purchase.

Because less of the purchase price is repaid in each payment, assuming interest rates are the same in both a hire purchase and a contract purchase agreement, the total interest charges in a contract purchase agreement are more than those in an equivalent  hire purchase agreement (because more money is left unpaid during the term).

The overall costs of finance for a contract purchase agreement are therefore normally higher than those of traditional hire purchase.

However, repaying a lower amount of the purchase price each month means that the actual monthly payments are lower in contract purchase than for a fully amortised hire purchase agreement and therefore more 'affordable' each month.

Advantages of Contract Purchase

Because the finance repayments cover just depreciation, rather than the full purchase price of the vehicle, the monthly repayments are less than those of Hire Purchase.

In addition, at the end of the contract the buyer can take ownership of the vehicle so it can profit from prudent management of the vehicle, such as achieving a better resale price than expected.

With an optional purchase and resale agreement the costs of running the vehicle are fixed during the replacement cycle, so the buyer can avoid unexpected costs.

Tax relief for the buyer on cars with a CO2 output over 110g/km is not limited in the same way as leasing, thereby reducing the total costs of contract purchase for cars with higher CO2 emissions compared to leasing, but there are deferrals of tax relief.

From April 2021 the CO2 threshold for tax relief deferral ('special pooling') will drop to 50GP/Km.

Disadvantages of Contract Purchase

If the contract is terminated earlier than expected then the buyer may be required to pay a penalty (usually a fixed number of instalments or the difference between the capital already repaid and the sales proceeds achieved on disposal of the vehicle).

Under accounting conventions applying at the date of publication, contract purchase must be disclosed on the balance sheet of a business as a liability. This can worsen the appearance of the financial position of a business.

For passenger cars (other than pool cars) VAT on the purchase price of the vehicle cannot be recovered, so the finance instalments are higher than comparable rentals for contract hire.

Lease or Buy?

To see the cost impact of leasing or buying your next new car or van click here.