Hire Purchase (HP) is likely the most common way household items are purchased and financed and is sometimes regarded as an easy way for persons of lesser means to afford certain necessities (or luxuries). But HP transactions are not straightforward. For clarity, we are not suggesting this is a reason to avoid them. On the contrary, our objective is to identify the points you should be aware of, so you have no cause for later regret.
In Part 1 we covered how HP works and noted the major advantages and disadvantages. In this Part 2, we discuss the financial aspects of HP transactions.
Expensive form of borrowing
Because HP loans are a riskier form of lending, HP is inherently expensive. As discussed in Be Uncomfortable With Debt, high loan interest rates have a real negative impact on your pocket and attempt to build wealth, so finding cheap financing is important. Of course, it is worth noting that interest rates are only one component of loan transactions, so good reasons could exist for you to choose a higher-rate financing option.
During the term of a HP contract, you are leasing (or hiring) the product from the retailer (or a finance company), and an interest rate is implicit in all leases. From our store walkabouts, it was not obvious what interest rate each retailer was applying – we assume you will be informed when you are ready to transact. But ultimately, not being told does not matter too much because you can estimate it yourself.
In HP terminology, a cash price of $10,000.00 will be displayed and the total HP price could be $12,000.00. The $2,000.00 difference is the interest amount, let’s say for 2 years. Most likely a weekly instalment of ($12,000 / (52 x 2) =) $115 will be shown.
The effective APR of add-on loans is much higher than traditional simple interest loans (e.g. mortgages). In the example, the add-on interest rate is 10%, but the effective APR is closer to 20% (assuming monthly instalments).
From the sticker prices in stores we visited, it appeared the effective APRs ranged between 20 and 30%, but based on displayed information, it is difficult to be more precise. See “Quoted prices” below.
Please note, similar to credit cards (see Understanding Credit Card Debt), we are not trying to assess whether the interest rate implied in a HP contract is a fair rate or not. These are complicated products and a lender has a right to charge whatever rate is needed to earn a return for the risk they assume. Instead, we are focusing on YOU and helping you decide if financing by HP is right for your circumstances.
When discussing a potential HP transaction, you should enquire what is the interest rate being charged and whether it is an add-on rate or APR. If you do not get a satisfactory answer, once you know the cash price and the instalments, you can calculate the APR yourself. Just take the details home and use an online calculator to determine the effective APR.
Surprisingly, even a credit card could offer a better rate and more repayment flexibility.
There are a couple points to consider with early repayments.
Firstly, can you repay early? Most agreements should allow for this, in which case, it would say you are entitled to an interest rebate – this simply means a reduction in the total interest you should pay. Now, when compared to a traditional loan e.g. a mortgage, you’ll realize that the concept of an interest rebate does not arise. So, why would you need a rebate for a HP loan?
The reason has to do with how your instalment was calculated (refer example above). Your instalment was based on the total interest due over the life of the loan, so if you are repaying early, you’ll no longer owe interest from when you intend to repay to the original loan end date. The portion of interest no longer due is “rebated” to you.
Rule of 78
The problem with early repayments is, if you wait too long to initiate repayment, the interest rebate could be quite small. This is because the retailer (or finance company) is most likely using the Rule of 78 to earn interest on your loan. Click here to read our post about it.
What you need to know is, under this method, interest is not spread evenly over the loan term. Instead, in the early loan periods, more of your instalment is allocated to paying interest than principal.
Once you have passed the halfway point of a loan, it does not make much sense to early repay, as you will not save much interest from this date.
From the agreements we’ve seen, no mention was made of penalties or fees for early repayments. You should double check this before entering into the contract.
Financing transactions commonly include the requirement for the borrower to have insurance. It is also fairly common for household goods to be sold with extended warranties.
From our walkabouts, it was not always clear if these items were bundled into the prices being shown, and consequently, what was the separate cost of either insurance or warranties. In fact, goods being protected by insurance seemed to be offered as a feature of the transaction, but it was not always made clear who was in fact paying for it (you or the retailer – we suspect you).
In both cases, it seems reasonable that you should have some sort of choice. For example, suppose you have separate insurance to cover the item, why would you need the retailer’s? Or suppose you would rather not incur the cost of the extended warranties, as these are sometimes quite expensive.
The point here is, there should be transparency for both these costs. Ask for a breakdown of the price with and without insurance and warranties.
Before wrapping up, here are a few points to consider.
You will be encouraged to enter into a transaction in various ways. The most pervasive being weekly instalments, but other inducements include 3 months no interest, 0% interest for a period, no down payment, etc. These all have a nil or marginal impact on your overall price. The weekly amount in particular is a sales tactic to highlight the item’s affordability: don’t get reeled in.
Focus instead on: the overall cost of the item, is it cheaper at another store, and can you finance it more economically.
We’ve touched on the issue of quoted prices in different related points. To address the point directly, we found the quoted prices difficult to interpret without assistance. The cash price (with VAT) is obviously ok, but to arrive at your HP price (and the often displayed weekly price) was not straightforward. Make sure you understand step-by-step how to arrive at your price.
Complications include: the cash price may not be the starting price for interest; the interest added is unclear; what is the cost for warranties and insurance; what other charges (e.g. delivery) are included; etc. If these are only disclosed “when you are ready to buy”, you may feel pressured to make the purchase. Be focused and gather the information you need to make a decision. Sleep on it if needed.
In our store walkabouts, we engaged various store clerks with questions about the transaction. While we often found their knowledge about the product being sold to be reasonable, their knowledge of HP was usually lower than what we expected.
While we expect sufficiently knowledgeable senior people are indeed present in each store, the point is, you need to educate yourself BEFORE walking into the store. Do not necessarily expect a discussion about HP and whether it is right for you.
HP legal agreements
Disappointingly, the HP agreements we reviewed were all written in legalese, as opposed to plain English. We expect only lawyers or persons exposed to financial services would be able to understand the legal contract terms. In a way, this circles back to the previous point, since the average consumer will be relying on store attendants to explain the transaction to them.
The point is, do NOT sign anything you do not fully understand. The contract terms exist for a reason and you should ensure you properly understand EACH one. If you are not comfortable with the in-store assistance, get outside help.
Cash price is king
The final point is probably the most important. While HP financing is an important option for consumers, ultimately, the best financial move is paying the cash price. If you cannot immediately afford a cash purchase, and the only financing option is an expensive HP loan, then consider just waiting and saving for the item. Either save to pay fully in cash or make a large deposit. Either approach will save you a lot in interest costs.
We hope you found the post helpful and now have a much better understanding of HP transactions. If you have thoughts or experiences to share, we’d love to hear from you in the comments below!