Hire Purchase

Updated on January 3, 2024

Hire Purchase Meaning

Hire purchase is a buying option where the buyer pays for goods in regular installments. But, first, the buyer has to pay a down payment. The buyer does not get the title of ownership until complete payment is made. This includes the principal and the interest.

Due to the interest, buyers end up paying more. In many countries, this mode of payment is also called the installment plan. A hire vendor is a seller or business entity that offers this mode of purchase to its customers.

Key Takeaways

  • Hire purchase is a legally binding agreement. A buyer or hirer disburses a percentage of the total cash price as a down payment. The buyer settles the outstanding sum and interest in periodic installments.
  • These transactions can also be executed with the help of a financier. The financier purchases the goods on the buyer’s behalf and makes payment to the seller. The financier presents the product to the buyer and collects the amount with interest.
  • It is a feasible buying option for low-income groups. Even expensive products can be purchased conveniently. Also, industries facing cash shortages do not want to spend a huge amount at once. 

Hire Purchase Explained

Components of Hire-Purchase

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Hire purchase is an installment-based method of procuring expensive consumer goods or assets. This method is used both by individuals and firms. The buyer makes a down paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more—a partial sum or a percentage of the total price. The remaining amount is paid in installments—inclusive of interest.

The purchaser pays a rent (hiring charge) for an agreed period. The frequency of installments could be yearly, quarterly, or monthly.

The buyer can acquire goods immediately, but the ownership of goods remains with the seller till the final payment is completed. If the buyer defaults, the seller has the right to seize assets. Also, the seller can claim depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more on sold goods and avail tax benefitsTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more. Similarly, the purchaser can claim income tax benefits on hire charges.

The following parties are involved in a hire agreement:

  • Hire Purchaser/Hirer: An Individual or organization purchases goods by paying installments.
  • Seller/Dealer: A business entity that sells goods.
  • Financier: A finance company funds the purchase.

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Hire Purchase Features

The following characteristics differentiate it from other modes of purchase:

Types

Based on the purpose of the purchase, it is categorized into two types:

Sometimes, a third party, i.e., the financier, purchases goods on behalf of the customer. This third party gets into a purchase agreement with the customer. Based on the agreement, the customer becomes the owner as soon as they pay the final installment. Till then, the financier owns the title of goods; The financier also pays the purchase price to the seller. Later, the lender recovers this amount from the customer—in periodic payments. In case of non-payment, the lender has the right to seize goods.

Alternatively, the consumer can directly enter into a purchase agreement—with the seller. If so, the buyer has to pay a down payment. Over time the buyer repays the remaining amount with interest—in periodic installments. The buyer becomes the owner once payment is completed.

Hire Purchase Calculation

For determining the purchase price, the following formulas are used:

Hire-Purchase Formula 1
Hire Purchase Formula 1-1
Hire-Purchase Formula 1-2

Here,

  • Cash Price is the current market price at which goods can be purchased.
  • Hire Purchase Price is the price at which goods can be purchased (as mentioned in the agreement).

Annuity to recover $1 over the given period is given by:

Hire Purchase Formula 1-3

Here,

  • r is the rate of interest.
  • n is the number of installments.

Example

on January 1, 2018. an Inc. purchased a machine on hire purchase from Z Ltd. Inc. paid $80,000 immediately and agreed to three annual installments of $80,000 each. The installments will be paid on December 31 of every year.

The machine’s purchase price is $298,000. If the vendor charges 5% interest per annum, calculate the purchase price, total interest, and the breakup of principal and interest paid by the buyer.

Solution:

Interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more can be calculated as follows:

#1 – Hire Purchase Price
Purchase Example 1
#2 – Total Interest
Example 1.0.1
#3 – Principal and Interest Paid Every Year
  1. The outstanding cash price at the time of the first installment is computed as follows:

Total Purchase Price – Down Payment = $298,000 – 80,000 = $ 218,000

First Installment:

  • Interest charged on the first installment:

Interest = 5% of Outstanding cash price = 5% of $218,000 = $10,900

  • The principal amount paid in the first installment:

First Installment – Interest Paid = $80,000 – $10,900 = $69,100

  • Outstanding amount after the first installment

Total Outstanding Amount – Principal amount paid in first installment = $218,000 – $69,100 = $148,900

Second Installment

  • Interest paid on second installment

Interest = 5% of Outstanding amount = 5% of $148,900 = $7,445

  • Principal Repaid in Second Installment

Second Installment – Interest = $80,000 – $7,445 = $72,555

  • Outstanding amount after the second installment

Total Outstanding Amount – Principal amount paid in second installment = $148,900 – $72,555 = $76,345

Third Installment:

  • Interest paid in the Third Installment

Interest = 5% of Outstanding amount = 5% of $76,345 = $3,655

Advantages and Disadvantages

This mode of purchase has the following benefits:

This mode of purchase has the following drawbacks:

  • Such a purchase imposes a fixed payment burden on the buyer, which is difficult to arrange during a cash crunch. 
  • The interest charged on such a purchase increases the final cost of goods.
  • Even after making a significant part of the payment, the ownership of goods or assets lies with the seller or financier.
  • If the purchased asset gets stolen or destroyed before it is fully paid for, insurance may not cover the liability.
  • Some financiers charge exorbitant interest rates.

Frequently Asked Questions (FAQs)

What is Hire Purchase?

It is a method of buying high-value assets or goods on credit. A percentage of the total purchase price is paid immediately as a down payment. The remaining amount is settled by paying periodic installments. On such a purchase, a flat rate of interest is charged.

How to calculate hire purchase?

It is the total amount paid by the buyer—the principal plus overall interest charges. The following formula used for calculation:

Hire Purchase Price = Down Payment + (Installment Amount × Number of Installments)
Also,
Total Interest or Hire Charge = Hire Purchase Price – Cash Price

Who is a hire vendor?

A hire vendor is a firm or seller who offers goods to buyers and enters into a hire agreement. In addition to the principal amount, hire vendors charge periodic interests on the due amount.

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