External sources of finance come from outside the business. Hire Purchase belongs to external sources of finance. When businesses need to use the money for a few years (between one and five years), this creates the need for medium-term finance.
3. Hire Purchase
Hire purchase occurs when an asset is sold to the buyer who agrees to pay fixed payments over an agreed period of time. The term of a typical hire purchase agreement generally spans over two to five years. The asset belongs to the buyer, but is legally the property of the creditor until all payments have been made.
How does hire purchase work?
Hire purchase allows a business to own the asset from the beginning, and yet, pay its creditors in installments over a medium-term. Usually, a down payment of 10%-30% is required to secure a hire purchase deal from the seller. Obviously, if the buyer defaults on the agreement by falling behind on repayments, then the lender can repossess the asset.
When to use hire purchase?
Hire purchase is used to finance certain Fixed Assets with a medium-term lifespan from one to five years. Those Non-Current Assets mainly include land, buildings, machines, office equipment, tools or vehicles. Hire purchase is used when the business wants to own the asset from the beginning, but cannot afford to pay the full price.
How is hire purchase different from leasing?
Hire purchase is a form of buying on credit, so interest is charged by the lender on the amount borrowed. It is different from leasing because the buyer will eventually own the asset on payment of the last installment. Legally, the ownership of the asset does not officially transfer to the buyer until all contractual payments are successfully made. The buyer, as the owner, is also responsible for any maintenance or repairs to the asset.
Benefits of hire purchase
- Permanent ownership. The asset belongs to the business. After making the last and final payment to the seller, the legal ownership of the asset will transfer from the creditor to the business. Because as a hire purchaser, the company will own the asset after the last installment, it makes hire purchase a favorable alternative to leasing.
- No need for a large initial investment. Both leasing and hire purchase enable a business to have the use of an asset without the need for a large one-off cash investment. Thanks for hire purchase agreements, even relatively ‘poor companies’ or start-ups can afford to own advanced or expensive assets.
- Fixed repayments. Repayments are scheduled up to five years, or even longer, depending on the buyer’s financial capabilities. The monthly, or quarterly payments, can even be financed out of Working Capital. Paying the same amount every single month will make it far easier for the business to fit in with monthly budget and forecast Cash Flow.
- Spreads out the large cost. Hire purchase makes it easier to buy very expensive things because the payments are spread over a period of time. It makes it easier for the business to buy the newest machines or the most advanced technology.
- Can be paid off ahead of schedule. Most hire purchase agreements allow the buyer to pay the remaining amount that is due earlier. So, if the business has money available, it can settle the agreement either partially or in full before the end of the term. This will eliminate the need to pay interest, therefore lowers Expenses, or Fixed Costs.
Drawbacks of hire purchase
- Need to pay a down payment. When purchasing expensive machinery or assembly lines, a down payment of 10%-30%, which is required to secure a hire purchase deal from the seller, might turn out to be quite costly. While it is possible to acquire the asset with a zero-down payment option for those with an excellent credit score, monthly payments will be much higher.
- Must pay interest. Both hire purchase and leasing are expensive as the interest charges are a part of the payment. And, interest can be quite high. Also, hire purchase contracts are usually fixed. It means that if the business finds itself in financial troubles, it may lose the asset and damage its credit rating. Interest rates will usually depend on the credit profile of the buyer.
- The seller can repossess the asset. In case the buyer defaults on keeping up with the payments, the asset can be repossessed by the seller. In case of hire purchase, the buyer does not become the legal owner of the asset until the buyer has paid the last installment. Usually, the amount that has already been paid towards the hire purchase agreement will not be returned to the buyer.
- Higher total cost of the asset. The buyer will end up paying more for the asset than if the company was to purchase outright.
- Costly repairs and maintenance. The business is responsible for any maintenance and repairs of the asset.
To summarize, hire purchase is a form of credit for purchasing a Fixed Asset over a period of time. This avoids making a large initial cash payment to buy the asset as only a relatively small down payment is required from the buyer.
