Hire Purchase

Hire Purchase Agreement Meaning

Hire Purchase is a kind of agreement where the buyer buying an expensive asset chooses an option to pay for the asset by paying some down payment at the time of purchase of an asset and clearing the remaining dues in regular installments including interest.

In simple words, it is a type of agreement whereby hiree (purchaser/lessee) instead of purchasing any asset by paying the full amount in cash agrees to pay a particular part as down payment, if agreed (initial payment) and balance as periodical installments (hire charges and principal) for a particular period of time. Under such agreements, the ownership of the goods may/ may not be transferred to the buyer until all the payments as agreed have been made. It is commonly used in the United Kingdom, and it’s more commonly known as an installment plan in the United States.

Types of Hire Purchase Agreement

  1. Under the first type, the third entity (lender) purchases goods on behalf of the customer and gets into this agreement with the customer. Under this agreement, the customer becomes the owner on payment of the final installment. The lender owns the ownership of goods, pays the purchase price to the seller and get it recovered from the customer. Here, a lender may seize goods in case of non-payment.
  2. Under the second type of agreement purchaser, himself enters into this agreement with the seller and pays to the seller, becomes the owner of goods on payment of the last installment. Here, a seller may seize goods in case of non-payment.

Components of Hire Purchase

Components of Hire Purchase

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For eg:
Source: Hire Purchase (wallstreetmojo.com)

  • Hire Purchaser/Hiree: Entity which purchases goods on a hire purchase basis.
  • Seller/Dealer: Entity who sells goods.
  • Down Payment: Initial upfront payment processed—example; 10% of the cash price.
  • Hire Charges: Amount paid for hiring or using goods. In simple terms, this can also be said as a rental charge for using an asset.
Hire Charge = Hire Purchase Price – Cash Price
Interest = Total amount due at the time of installment x rate interest /100 t rate of interest
  • Cash Price: Current market price at which goods can be purchased.
  • HPP: Price at which goods can be purchased under this agreement.

Calculation Examples of Hire Purchase

You can download this Hire Purchase Excel Template here – Hire Purchase Excel Template

Example #1

An Inc. purchased a machine on hire purchase from Z Ltd on January 1, 2018, paying $ $80,000 immediately and agreeing to pay three annual installments of $80,000 each on December 31, every year. The cash price of the machine is $2,98,000, and the vendors charge interest @ 5% per annum. Calculate the following:

  • Hire Purchase price
  • Total Interest Paid
  • The breakup of Principal and Interest paid by the buyer to the seller every year.

Solution:

Amount of interest paid will be calculated as follows:

#1 – Hire Purchase Price

Hire Purchase Example 1

#2 – Total Interest

Example 1.0.1

#3 Principal and Interest Paid Every Year

  • Outstanding Cash Price at Time of First Instalment = $ 2,18,000
Hire Purchase Example 1.0.2
  • Interest on First Installment Rate of Interest =$10,900
Example 1.0.3
  • Principal Paid in First installment = $69,100
Hire Purchase Example 1.0.4
  • Outstanding Cash Price =$1,48,900
Example 1.0.5
  • Interest on first installment Rate of Interest = $7,445
Hire Purchase Example 1.0.6
  • Principal Repaid in Second Instalment = $72,555
Example 1.0.7
  • Outstanding Cash Price =$76,345
Hire Purchase Example 1.0.8
  • Interest paid in third Instalment = $3,655
Example 1.0.9

Calculation of Cash Price and Interest

Note:
Annuity to recover $1 over the given period of time is given by
Cash Price = Annual Instalment x [(1+r)n -1]/r-(1 + r)n – 1
(Where r is the rate of interest, n is number of installment)

Example #2

Calculate Cash Price with the following information: –

  • HPP =$90,000
  • Three equal yearly installments (Principal + Interest)
  • Interest Rate = 5%
  • The present value of $1 annuity of 3 years value @5% is 2.723

Solution:

Calculation of HPP will be –

Hire Purchase Example 02

Alternatively,

Calculation of Cash Price will be –

Example 2.0.1

Please refer given excel template above for detailed calculation.

Important Points

  • Purchaser pays a rental (the Charge for hiring) for an agreed period of time.
  • If the purchaser makes default in payment, the seller has the right to recover/seize assets from the purchaser.
  • Frequency of installment may be yearly/quarterly/monthly etc.
  • Goods possession gets transferred initially, but ownership of goods remains with the seller until the payment of the final installment.
  • Usually, the purchaser pays a certain percentage of cash price as a down payment.
  • Since property in goods vests with a seller, he can claim depreciation on sold goods for income tax benefit purposes. Similarly, the purchaser can claim income tax benefit on hire charges (Hire purchase price minus Cash price).

Advantages

Disadvantages

Some of the disadvantages are as follows:

  • Since it creates a fixed amount of payment burden on the purchaser, he may find difficulty in payment during a cash crunch position. This may also lead to loss of the asset and damage your credit rating.
  • The cost of purchasing an asset will always be higher than purchasing on the cash price.
  • Legal ownership vests with the seller, which may seize the same in case of non-payment of hire purchase installments;
  • If the purchased asset gets stolen/ destroyed before it is fully paid for, the insurance may not cover the replacement value, which may lead you to face a shortfall (in recovery).

Conclusion

Based on the above discussions, advantages, disadvantages discussed and shared, it cannot be outrightly said that purchasing an asset on hire purchase, in cash, a loan, or lease is best. The mode of acquisition shall be decided by multiple factors based on each individual organization. But yes, it is a good option in case the entity wants to use the asset without processing 100% payment at once. However, it is a costlier method of acquisition rather than Cash Purchase as it will always include hiring charges/interest element.

Recommended Articles

This has been a guide to what is Hire Purchase Agreement and its meaning. Here we discuss the most common types of hire purchase agreement along with calculation examples & explanations. We also discuss the advantages and disadvantages. You can learn more about accounting from following articles –