What is Hire Purchase
Created | Updated Nov 17, 2004
What exactly is hire purchase and should I be bothered with it?
Hire purchase is a form of financing. It is the letting of goods (cars, refrigerators, tables etc.) with an option to purchase the goods, and an agreement for the purchase of goods by instalments. This Entry deals with hire purchase for the personal consumer1.
What should I know about hire purchase?
Basic terms
Even though the hire purchase laws may vary from country to country, the basics are the same. All hire purchase of goods will involve a:
- ‘Hirer’ - the person who is wants the goods
- ‘Dealer’ - the person who is selling the goods
- ‘Guarantor’ - the person who is guaranteeing that the hirer will be able to pay the instalments
- ‘Owner’ - the person who has let the goods to the hirer under a hire-purchase agreement). The ‘owner’ is usually the bank, finance company or credit company
There are two types of hire purchase – simple interest and reducing balance interest. Of the two, the simple interest form of hire purchase is less customer friendly in the way the interest is calculated, but has been more widely practised until recently where it is slowly being phased out. However, many developing countries still practice the simple interest method.
How to calculate it
To calculate the simple interest that a consumer will incur, the Rule of 78 formula is used. It is also known as the ‘Sum of Digits Approach’ because the number 78 is the sum of the numbers from one to 122.
As an example, let’s say that total interest that will be incurred by a customer will be £3000 and it will be paid off in a 12 month period.
| Month | Numerator | Denominator | Monthly interest |
|---|---|---|---|
| 1 | 12 | 78 | 461.53 |
| 2 | 11 | 78 | 423.08 |
| 3 | 10 | 78 | 384.62 |
| 4 | 9 | 78 | 346.15 |
| 5 | 8 | 78 | 307.69 |
| 6 | 7 | 78 | 269.23 |
| 7 | 6 | 78 | 230.77 |
| 8 | 5 | 78 | 192.31 |
| 9 | 4 | 78 | 153.85 |
| 10 | 3 | 78 | 115.38 |
| 11 | 2 | 78 | 76.93 |
| 12 | 1 | 78 | 38.46 |
| Total | 78 | 3000.00 |
The formula to calculate the monthly interest is:
Numerator ÷ Denominator x Total interest
Where the numerator starts with the total number of instalments and decreases, and the denominator is the sum of the digits from one to 123. The total monthly interest is calculated by the formula below:
Loan amount x Flat interest rate x Loan tenure (number of years)
For example, if the loan amount is £100,000 and the simple interest rate is 5% per annum for a period of 2 years:
100,000 x 5% x 2 = 10,000
Financing period
Financing periods vary depending on how many years the finance company will allow the consumer and how much the consumer can pay each month. It can be from a year to nine years. The longer the loan tenure, the lower the monthly payments will be. However, the consumer should be aware that the longer the loan tenure, the more the amount of interest they will have to pay to the finance company. In deciding the length of the financing period, the consumer should take into account the amount of interest they can afford to pay per month as well as the useful life span of the asset being purchased. For example, if you are taking out a nine-year loan for a car that you are going to replace after 5 years, you may want to reconsider your financing options and strategies as you will be losing out in terms of the amount interest you have paid.
