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What Is Contract Purchase?

Contract purchase is a way of acquiring a vehicle on finance but deferring part of the payments until the end of the contract.

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

In typical contract purchase arrangements the fleet operator 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 fleet operator 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 fleet operator 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 fleet operator to simply return the vehicle to the finance company at the end of the agreement.

What's in Contract Purchase Payments?

 The finance company has to 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 instalments comprise:

Depreciation
Interest Charges
Profit Margin
Maintenance (Optional)

Normally the finance company will include the VED or 'tax disc' 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.

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 fleet operator 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 fleet operator can avoid unexpected costs.

Tax relief for the fleet operator 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.

Disadvantages of Contract Purchase

If the contract is terminated earlier than expected then the fleet operator 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.

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