Depreciation is a term used to describe the drop in value of an asset (such as a car) over time. In the following guide, we explain what depreciation is and how it could affect your car finance agreement.
If you own an asset, the likelihood is that it will depreciate in value with age or use. Although a few specific assets such as homes and classic cars may appreciate i.e. increase in value, most others will lose value the older they get.
Unfortunately, most people are unable to afford a classic Ferrari which may appreciate, and there are very few cars that will ever fall into this fortunate category. The vast majority of us will own vehicles that decrease in value as they have travelled more miles and suffer wear and tear over time.
Depreciation is the amount of value that an asset loses from the original price that it was purchased for. As we have mentioned, most assets will depreciate and this simply means that they will be worth less once they begin to age and are more heavily used. Cars are a perfect example of depreciation. While most people see a vehicle as a necessity, they will also understand that the more miles they drive in the vehicle and the older the vehicle becomes, the less it will be worth.
Yes! Unfortunately if you like new things then the depreciation that you incur will be high. It's a common fact that products lose value when they’ve already been owned or used by someone else. The heavier the use, the more value will be lost. The only things that tend to appreciate are homes, but this will depend on where you live and the state of the market. For instance, research conducted by Halifax shows that over the last 20 years house prices in the UK have increased by 306%.
However, houses are one of the few assets that might increase in value. Cars on the other hand almost always lose value. According to The AA, if you purchase a brand new car then by the time it has travelled 30,000 miles (over a three year period) the average vehicle will have lost 60% of its value.
It's unlikely that you will completely avoid depreciation with any products that you purchase. It doesn’t matter if you buy a car, a phone or a DVD; all of these products will lose value once they have been used. Although you might not be able to completely avoid depreciation, you might be able to limit the effect it has. For instance, certain products and brands will hold their value far better than others. In the motoring industry for instance if you buy a car that has a strong brand, such as Volkswagen and Audi, the vehicle will depreciate slower than a Ford or Vauxhall. This is partly due to reliability, demand and the status associated with particular brands.
This also means that choosing the right car when you are buying will have a big impact on the overall cost. If you buy a car for £8,000 which 5 years later is only worth £2,000 you are actually going to have less value than if you have purchased a vehicle for £10,000 that 5 years later is worth £5,000.
£8,000 – £2,000 = £6,000 total cost when you include remaining asset.
£10,000 – £5000 = £5,000 total cost when you include remaining asset.
When it comes to a Hire Purchase car finance arrangement, depreciation does not affect this type of finance as you will own the car outright by the end of the agreement. You may need to watch out for negative equity if you do not complete the finance agreement, but the vast majority of people will pay off the full finance amount on the car, so this is not an issue.
If you decide to lease a vehicle (such as in a Contract Hire agreement), then depreciation will impact the amount you pay each month on the finance agreement. When you are leasing a vehicle, you do not own the car you are driving and therefore the leasing company has the risk because they take back the car once it has been used. It is their job is to estimate what is known as the ‘residual value’, which is the amount the car will be worth after it has been driven over the term of the lease for the agreed miles. If you choose to lease a car that will depreciate quickly, the residual value will be lower at the end of the lease. Therefore the car you return will be worth less to the lease company. For this reason they will increase the amount you pay each month to cover the level of depreciation.
There are a number of car finance options on the market other than Hire Purchase, such as Personal Contract Purchase and Lease Purchase. These agreements work in a similar way to a leasing agreement, except there is the option to purchase the car at the end by making a balloon payment. This payment is based on the guaranteed future value of a car – which is the value that the lender calculated the car to be worth by the end of the contract, according to the amount they predicted it would depreciate by.
In accountancy, depreciation refers to two aspects of the same concept:
1. The decrease in value of assets (fair value depreciation), and
2. The allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).
How does residual value affect my leasing agreement?
This data has been put together with help from the Creditplus Customer Advisors.
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