What is the residual value of a car and why does it matter?

Navigating the world of car finance can sometimes feel like you need to learn a whole new language! Parlez-vous de financement automobile?
 
Don’t panic; we’re not about to take you back to GCSE French (we still get nightmares), but we can translate the jargon and explain all the acronyms so you can continue your car buying journey with confidence.
 
Residual value is one of the most important terms you need to know if you’re considering Personal Contract Hire (known as PCH or leasing) or Personal Contract Purchase (PCP) finance.
 
With both these types of finance, your car’s residual value will be determined at the start of your agreement and could impact how much you need to pay each month.
 
It’s all down to depreciation. Almost all cars start losing value as soon as they leave the dealer forecourt, but the speed at which this happens can be affected by a wide range of factors including the number of miles you drive.

What is residual value and how is it calculated?

Let’s start with the dictionary definition: residual value is the term used to describe how much your new wheels will be worth when your lease or finance agreement ends.
 
It’ll usually be estimated by the leasing company or lender before you sign your agreement – an educated guess based on how much value the car is likely to lose over the length of the contract.
 
It’s not an exact science, but residual value will typically be based on several factors including the make and model of your car, industry trends, the loan or lease term length, and the agreed annual mileage limit – all of which affect a vehicle’s rate of depreciation.

What factors affect car residual value?

Your wheels’ residual value can be improved (or reduced) by many different factors, some related to the car itself and others to the way you drive it:

Mileage

A good rule of thumb: the more miles on the clock, the less your car will be worth. If your pride and joy spends most of its life parked in your garage, it’ll probably retain its value better than if you spend hours each week powering up and down the motorway.
 
It's worth keeping in mind that most leases and PCP agreements will ask you to agree to a set annual mileage limit at the start of your contract. Penalty charges will usually apply for every extra mile as they could impact the car’s residual value.

Colour

You might not think your car’s colour would be a dealbreaker, but you could be surprised by the affect it can have on its resale value. Everyone has preferences (we’re hot pink fans ourselves obviously), but neutral shades tend to be universally popular. Think blue, black, grey, and silver rather than neon green or custard yellow.

Condition

As your car ages, some wear and tear will be expected, but damage (including hidden issues) that goes beyond a few small scrapes and scratches could harm its residual value. If you’ve been involved in a more serious accident or have parts that need replacing, you might find you have to pay extra to cover the cost of fixing these issues at the end of your lease or if you choose to return a car on PCP.

Age

All cars (except collectible classics) lose value as they age, but they tend to depreciate fastest in their first few years of life. After this, the rate of depreciation slows down so don’t be surprised if the residual value of a car that’s three years old isn’t wildly different to a model that’s reached five or six.

Fuel efficiency

With fluctuating fuel prices hitting the headlines in recent years, fuel efficient cars are more sought-after than ever. The more miles per gallon (or mpg as you might see it abbreviated to) you’re able to get from your pride and joy, the more desirable it will be over time.

Market demand

The used car market goes through ups and downs with different models gaining popularity at different times (maybe next year the Nissan Micra will have a moment?) The trends can be impossible to predict, but the current demand for each make and model can affect its resale value.

What is the impact of residual value on car finance payments?

With PCP finance, your monthly payments will be partially based on the car’s residual value.
 
While your individual circumstances, credit score, loan term length, and the car you buy will all affect the loan you get and the amount of interest you need to pay each month, your overall PCP loan amount will be largely dictated by the car’s residual value.
 
That’s because PCP works differently to other types of finance like Hire Purchase (HP). Instead of taking out a loan to cover the car’s full purchase price (minus any deposit), with PCP, your loan is equivalent to the difference between its purchase price and its estimated residual value at the end of the agreement.
 
This figure is set at the start of your PCP agreement and is also known as the Guaranteed Minimum Future Value (GMFV) and presents itself as something called a balloon payment at the end of your agreement. If you want to buy the car at the end of the PCP term, you’ll need to pay this amount (or refinance it) to become its legal owner. 
 
If the difference between the car’s current value and its GMFV is small, you’ll only need to borrow a small amount of money and could have lower monthly repayments. On the other hand, a larger difference will usually mean higher monthly repayments.
 
Keep in mind that extra charges apply if you exceed your annual mileage limit or damage your wheels beyond fair wear and tear.

How does residual value affect leasing?

Residual value is also one the factors that can affect how much you’ll need to pay on your lease each month.
 
It’s not the only consideration – the car’s make, model, and mileage, and your own personal circumstances will also play a role – but it is an important one.
 
In most cases, the smaller the difference between the car’s current value and its residual value, the lower your lease payments will be.

How can I choose a car with a strong residual value?

Every car loses value at different rates based on industry trends, how it’s driven, and how well it’s looked after.
 
If you’re looking for a model that will hold its value over time – and have a strong residual value as a result – there are a few things to keep in mind when browsing the listings or exploring a dealer’s forecourt:

Choose a neutral colour

Neutral colours like blue, black, grey, and silver tend to retain their popularity over time while more adventurous shades can be in vogue for a short time and then fall out of favour.

Choose a fuel-efficient model

Fuel efficiency is always desirable. If you buy a car that burns fuel quickly and racks up big bills at the pump, it will likely have a lower residual value than a model that’s more efficient with a high number of miles per gallon.

Choose a reliable manufacturer

Some manufacturers have a reputation for reliability. The likes of Toyota, Volvo, Hyundai, and Lexus are known for producing quality vehicles that don’t break down very often and so are more likely to stay in demand over time.

Choose a low mileage

When buying a used car, a model with a low mileage will be more desirable than one with several thousand miles under its belt. If you’re looking to buy a second-hand model, choosing one with a low mileage will also give you more wiggle room to put some more miles on the clock without affecting its value too negatively.