Pros & cons of Hire Purchase

Advantages and Disadvantages of Hire Purchase

If you have ever been in the market for big ticket items or planned for substantial capital investments, chances are that you would have considered hire-purchasing as a potential financing option. From as far back as nineteenth century England, which saw the emergence of these contracts and its rapid adoption through the crown colonies, until today’s car market, hire purchasing has been a popular option with customers considering an expensive purchase.

 

Considering just how commonplace these contracts have become, it can come in a number of guises (for example it is known as an installment plan in the USA or simply a car loan in Malaysia) and flavors but all adhere to the same basic principles. At the heart of it, hire purchase contracts involve an exchange of goods between buyer and seller after an initial payment or set-up fee, with the outstanding balance being paid with interest over a period of time. However, the defining aspect comes with ownership of the asset. Throughout the tenure of the contract, ownership of the goods remains with the seller or financial institution drafting the contract. It is only upon conclusion of the agreement, that the buyer has an option to go ahead with the purchase for a charge called an option-to-purchase fee. After which, ownership then transfers to the buyer. Such an arrangement presents several advantages and a few disadvantages to an individual or enterprise. 

 

Advantages of Hire Purchase

1. Ready to Use

The most immediately apparent advantage of hire purchasing is that the asset or good can be immediately utilised and put into service with much less initial outlay than would otherwise be required. This typically ranges from a deposit or set-up fee of 10% for most assets, to 30% for new vehicles. A business that needs to make capital investments to kick-start its operations could find this the most expedient choice. 

 

2. Easing the Financial Burden

Similarly, the financial burden is also reduced since payments are periodic and spread over a length of time. Start up costs can be significant but absolutely essential and so breaking up this commitment into smaller pieces can dramatically alleviate the financial strain.

 

3. Lower Interest with Secured Lending

Hire purchasing can also be a cheaper form of financing. The nature of these contracts makes it similar to collateralised loans, since the asset ownership only legally transfers to the buyer at the end of the agreement. As such, interest rates are generally lower than other forms of business financing like unsecured term loans. Assuming that the buyer does not terminate the agreement or repay early, the EIR (Effective Interest Rate) of hire purchase agreements can vary at about 5-6%3 as compared with unsecured loans that may be as high as 9%4.

 

4. Flat Interest Rate

Another advantage is that hire purchase contracts have a flat interest rate. This means that the interest rate remains the same across the life of the contract without fluctuating. This may or may not be beneficial depending on the prevailing interest rates but it keeps payments predictable and thus makes budgeting, as well as cash flow management easier.

 

5. Accounting for Hire Purchase Contracts

For those keeping close tabs on their finances, there are also some tax and regulatory upsides to using hire purchase contracts to finance asset purchases. The first is that GST (Goods and Services Tax) is not charged on the interest portion of the contract so there are no additional financial obligations owed to the government in this area. Next, is that a tax relief can be claimed on qualifying fixed assets under the Hire Purchase Act in Singapore. Referred to an asset allowance, 100% of the price of goods can be written off over 1, 2 or 3 years, allowing the buyer to manage the amount of tax payable. Lastly, even the interest portion is listed as a qualifying allowable business expense which can be used to reduce the amount of tax payable.

With regard to accounting, the treatment of hire purchases on the books can have several benefits. This is because equipment obtained this way is not counted as part of the company’s assets, at least until ownership has been transferred through the exercise of the option to purchase at the end of the contract. One prime example is the analysis of metrics such as fixed assets turnover, that investors and other stakeholders might be interested in. Since the fixed assets turnover is expressed as a fraction of turnover against the value of fixed assets, a company could reap the benefits of larger turnover as generated by new equipment and machinery, without having the value of the same assets on the books. The same case can be made for other measures of operational efficiency like return on gross fixed assets or return on net assets.

*Note: The above information on Tax & Accounting treatment is strictly for reference only, business owners should seek professional advice from your own tax consultant or auditor.

 

Disadvantages of Hire Purchase

1. Overspending

Just as there are many good reasons to opt for this method of asset financing, there are several drawbacks too. The advantage of perceived affordability is a double-edged sword. With financing available, an entity may be proverbially biting off more than it can chew and proceed with a purchase under a hire purchase contract when it would be more prudent to put it off. There could also be the temptation to choose more expensive or technologically advanced options that now become within reach. As a contract between buyer and seller, terms can be priced, negotiated and included or omitted while it is being drawn up. Zero downpayment, for instance, allows the buyer to take home the goods with nothing out of pocket. However, this would surely increase all or any of the other terms like duration and interest.

 

2. Inflexible Contracts

In the event that a company over extends itself and defaults on payments, the item can legally be repossessed. On the other hand, if a company subsequently finds itself in a position to make full payment, it may not always be possible to repay early or there could be additional fees involved to do so. With a payment default, it doesn’t just end in the seller regaining possession of the asset either. It will go on record and have a negative impact on the buyer’s credit profile, affecting the ability to apply for financing in the future. This also includes any future decisions to enter other hire purchase contracts, as the terms are dependent on the applicant’s credit history, and a better credit score usually results in better terms.

With the introduction of Total Debt Servicing Ratio (TDSR) in Singapore to calculate an individual’s capacity to obtain financing, especially for home ownership, the number and value of hire purchase contracts one holds comes into consideration. The contract to take home the latest electronics or speed home in a sports car will have an impact on getting a home loan.

 

3. Asset Obsolescence

Finally, the length of the contract might be a substantial amount of time, stretching into years. By that time, the asset could have depreciated so much that it has no value at the end of the contract. In such a scenario, it might be better to take on a finance lease which could potentially be more cost effective.

 

Who benefits from Hire Purchase?

As we have seen, with its unique set of pros and cons, hire purchasing may not be the most suitable alternative for every individual or business but it still plays a vital role in the litany of financing options available. Small scale businesses and entrepreneurs can benefit most from hire purchase. High value, crucial and strategic assets can be hired and later owned. This ensures that they can start using the asset right away from the very first day and use the money generated to acquire the very same assets later.

 

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