A new car I could afford. Or could I?

Welcome to the slippery world of the personal contract purchase. By Paul Horrell

Look before you lease. Recently I needed to buy a car. Having trawled the second-hand stock at local dealers, I was agreeably surprised to end up with a brand new car that wore a windscreen sticker price of nearly double the figure I'd first had in mind yet was eminently affordable: the monthly loan payments were much as I'd budgeted for. There just had to be a catch.

Indeed there was. More than one, in fact. But the lure of a brand-new car is enough to persuade around a third of all Britain's private buyers to join the same kind of complex finance deal as I did. Welcome to the slippery world of the personal contract purchase (PCP).

Three years ago, the arrival of the personal contract purchase must have seemed like magic: suddenly private buyers could finance a new car on monthly payments far lower than those of traditional hire-purchase or bank loans. This works because you are deferring much of the cost until the end of the loan.

A new Peugeot 106 Rallye provided my education into the workings of a PCP. I could find pounds 1,500 as deposit. I wanted to keep the payments to as near pounds 150 a month as I could. I'd be doing about 12,000 miles a year, and would finance the car over two years. (It's important to be realistic at the start about your annual mileage, because PCPs have expensive clauses in which the dealer can charge for every mile you've driven beyond the agreed total.) The salesman went to work. The first thing he did was to lay down a "minimum guaranteed future value" (MGFV) for the car at the time I was due to part with it, two years and 24,000 miles down the road.

My monthly payments were based on the difference between the MGFV (pounds 4,500) and the car's new price (pounds 8,750 after I'd haggled) less the pounds 1,500 deposit - that's pounds 8,750 less pounds 4,500 less pounds 1,500 which comes to pounds 2,750. Spread that sum across the agreed 24 months, add interest on the whole cost, and that's the basis of the monthly payment calculation: pounds 188 in my case. On traditional hire purchase I'd have been shelling out an impossible pounds 350 or so.

PCP monthly payments are this low because you aren't actually paying off the MGFV component of the new price, whereas on HP or a loan, you buy the entire car. No, at the end of the PCP period, the fun is only just starting.

After those 24 months, several options present themselves. The first is to pay the MGFV as a lump-sum and keep the car, at which point you formally assume ownership. In my case, that could mean borrowing the pounds 4,500 from the bank, and repaying over two further years. The second option is simply to hand the car back, pay no more and take the bus home. That's why the final payment is known as the minimum guaranteed future value - it's the minimum trade-in allowance for that vehicle at that age, so the dealer is in effect taking it off your hands for exactly the amount you owe on it. But not only will you be stranded, this doesn't please the dealer either. He wants to sell you another car. So he offers you a third choice.

The dealer will usually make you an offer for the car higher than the MGFV, provided you use the car as a trade-in for a new one. After my two years, another similar new Peugeot will probably have risen to pounds 10,000. The MGFV, remember, is pounds 4,500. But if I deal hard the dealer might offer me pounds 5,500 for my car as a trade-in. So I'll have pounds 1,000 as equity in my car (the difference between the final payment and the dealer's bid), and will be able to use that towards a new deposit. The monthly payments would be barely higher than before, and I'd be back in a shiny new motor.

Ford Credit, which now has 150,000 private customers driving Fords on the Options PCP, reports that at the end of their agreements 70 per cent of them take that third option: they roll forward into a new scheme for a new car.

Satisfied customers? Yes, but with one proviso. It's hard for them to switch to another manufacturer, so they are sucked back into the same maker's PCP cycle. When the PCP term is drawing to an end, you can't legally sell the car because it's got outstanding finance on it. So if I wanted to swap the Peugeot for a Fiat, say, I'd have to borrow pounds 4,500 to pay off the MGFV (and realise the equity, too), sell the car, and repay that short-term loan. Only then could I set about buying another vehicle.

However, there's a bigger catch if you're not careful. Tempted by low monthly payments and using your existing car as a deposit, you might buy a car you can't afford to keep. Imagine you currently own a pounds 5,000 vehicle. Trading that in, and using the money as deposit, will enable you to buy, say, a pounds 15,000 new one on a PCP for perhaps pounds 250 a month over two years. The MGV might well be pounds 9,000. Even if that car is worth pounds 11,000 two years hence, you'll have only pounds 2,000 equity, - pounds 3,000 less than you started out with. Moral: make sure, before starting a PCP, that you have a clear view of the position at the end.

Other ways to buy a car

Personal leasing: A new scheme, whereby you don't have the option to buy at the end of the lease. You pay three instalments up front, then, after three months, start paying the monthly rental. Normally all maintenance is included.

Bank loan: Interest rates might be high but you own the car, so you're free to sell at any time.

50/50: Offered only by certain manufacturers. You pay half the car's price up front, then nothing for two years. Then you pay the other 50 per cent. So, you have an interest-free loan: but the second payment will be perilously close to the car's total worth at two years old.

Hire purchase: Monthly payments look expensive unless you lay down a big deposit, but you're paying off the whole price so the car is yours at the end without a final lump-sum MGFV payment.