What is car finance and how does it work?

May 24, 2023 by

Most new car purchases in the UK are funded by some kind of finance package. Read this car finance advice guide to help find the best option for you.

A financial package that sees you pay off a car (or its depreciation) in monthly instalments is the most popular way in the UK to get a new car on your driveway — hardly surprising given even the most affordable models on the market cost around £14,000.

When you buy a new car from a dealer, broker or a car supermarket you’ll always have the option to pay in cash, but you’ll likely be offered a finance package, too.

There are four core options when it comes to financing: hire purchase, a personal contract purchase, personal leasing, or a personal loan. As with any financial decision, it’s important to understand what you’re signing up to.

The best deal for you will depend on a number of factors including the interest rate being offered, how quickly an individual car is likely to depreciate, your budget, how long you want the financial contract to last, and whether you want to upgrade your car in a few years’ time, or have the option of owning the vehicle outright.

Read on for all the details about car finance.

Check out this handy video guide for the top 10 things you need to know about car finance…

What are the different car finance options available?

There are four main car finance options available to you, these are Personal Contract Purchase (by far the most popular scheme), Hire Purchase, Personal Contract Hire and a personal loan. This guide will go into detail on all these methods below so you can decide which is best for you. Keep in mind though that buying in cash is always an option.

Personal contract purchase or plan (PCP)

Who offers it? Car dealerships, car supermarkets and finance brokers
What for? Mostly new cars, some used cars, but not private sales

How personal contract purchase works

PCP effectively sees a car’s depreciation paid off in monthly instalments over the course of a number of years – typically three or four.

If you go for a PCP deal, you’ll pay a deposit (usually at least 10% of the car’s value — sometimes more) and then make a set number of monthly payments, which will – together with the deposit – pay off the car’s predicted depreciation over the course of the contract.

Your monthly payments will be based on the price of the car, the interest rate (APR) and how the car’s value is expected to drop over the course of your agreement.

Depreciation is the key to understanding PCP finance. Cars will lose value as soon as you drive them off the forecourt, though some lose a lot more than others.

When you apply for a PCP finance plan, the finance company calculates a predicted minimum value for the car at the end of the agreement. This is called the ‘guaranteed minimum future value’ or GMFV.

At the end of a PCP deal you have three options:

  1. Return the car with no additional fees
  2. Pay the optional  ‘balloon payment’ (which is the remainder of the car’s value) if you want to own the car outright.
  3. Use any overpayments (commonly called equity) you may have made if the car has depreciated less than predicted to go towards the deposit for a new car from the same brand or finance house.

Pros of PCP

  • Flexible package with three options at the end
  • Some manufacturers may offer a ‘deposit contribution’ towards the cost of a finance package
  • PCP agreements mean you can change your car reasonably frequently

Cons of PCP

  • You will need to stick to the terms in the contract, including a maximum annual mileage. Fees apply if you exceed the stated mileage.
  • You won’t own the car unless you make the optional balloon payment
  • If you damage the car, or there is excessive wear and tear, you’ll be charged extra at the end of the term.
  • Balloon payments can be high

Hire purchase (HP)

Who offers it? Car dealerships, car supermarkets and finance brokers
What for? New and used cars, but not private sales

How hire purchase works

HP are a more old-fashioned type of finance package and, rather than a PCP deal where you pay off only the depreciation, an HP agreement sees you a deposit followed by monthly repayments (with interest), which combined pay off the total of the car’s value over the course of the deal. HP contracts usually last one to five years.

You won’t own the car until you pay a ‘transfer fee’ or ‘option fee’ at the end of the deal. It’s important to understand you won’t own the vehicle until this payment is made – this means you can’t sell it without the lender’s permission — though this final fee is often relatively low.

Pros of hire purchase

  • You can pick a HP term to suit your budget; the longer the term, the cheaper your payments will be (but the more interest you’ll pay overall).
  • Once you’ve made all the payments and paid the transfer fee, the car is yours to keep or sell on
  • If you have a poor credit history, it might be easier to be approved for HP than a personal loan.
  • There tend not to be limits on the mileage you can cover each year

Cons of hire purchase

  • The car is owned by the finance company until the last payment and transfer fee are paid
  • You can’t sell or modify the car during the HP term without permission from the finance company
  • Monthly repayments can be more expensive as you’re paying off the entire car, not just its depreciation
  • If you fail to keep up repayments, the finance company can repossess the car. It won’t need a court order to do this until you’ve paid a third of the total amount

Personal contract hire (PCH)/car leasing

Who offers it? Car dealerships, car supermarkets and finance brokers
What for? New cars, used cars, but not private sales

How personal contract hire works

Personal Contract Hire (PCH) is more commonly known as car leasing, and is effectively a long-term rental agreement. You pay a deposit, then an agreed monthly amount over a number of months or years, and get use of the car for the duration of the term. You’ll have to pay for any damage that occurs during the lease (beyond fair wear and tear).

Most car leasing agreements run for two to five years, and the deposit is normally equivalent to three to six times the monthly payment. In general, the longer the agreement, the lower the monthly payments.

The key difference between PCH and PCP is that with PCH you will need to hand the car back at the end of the contract – there’s no contractual option to buy it.

Most PCH deals are aimed at businesses. For this reason, many deals are priced excluding VAT. Before you sign up, check if an advertised price includes VAT or not. If not, you’ll need to add 20% to the monthly price to arrive at the amount you’ll actually pay.

Pros of PCH

  • You don’t need to worry about a car’s depreciation with PCH finance
  • Delivery, breakdown, road tax and a warranty are often included in PCH deals
  • Monthly payments for a similar car tend to be cheaper with PCH than PCP
  • You can change car reasonably often

Cons of PCH

  • Deposit requirements tend to be higher than for PCP
  • There’s no option to buy the car at the end, no matter how much you like it
  • PCH deals come with mileage limits – there are financial penalties if you exceed them
  • You’ll have to pay for any damage beyond normal wear and tear at the end of the term
  • You might need to pay for the finance company’s permission to take the car abroad

Personal loan

Who offers it? Banks, building societies, peer-to-peer lenders
What for? New cars, used cars, private sales

How personal loans work

When you take out a personal loan, you borrow a fixed sum then repay it in fixed monthly payments, plus interest. Loan terms vary greatly, but are usually from one to seven years.

Interest rates vary depending on the amount of money you’re boring. Loans for smaller amounts usually attract a higher APR (more interest), while loans for £15,000 or more will often have a lower APR.

Using a loan to buy a car effectively makes you a cash buyer whether you’re buying a car from a dealer, a car supermarket or through a private sale.

Personal loans can be secured or unsecured. Secured loans are usually cheaper but they will normally be secured on your home – so your property will be at risk if you fail to keep up repayments. Unsecured loans are typically less risky but will cost more in the long run.

Pros of personal loans

  • There is a wide choice of loan providers from banks and building societies to peer-to-peer lenders and specialist car loan companies
  • You can use a personal loan to buy from a private seller
  • As a cash buyer you may be able to negotiate a better price for the car
  • You can choose to pay part in cash for your car, and cover the rest with a loan
  • You own the car from day one and are free to modify it, drive unlimited miles, or sell it

Cons of personal loans

  • Monthly payments might be higher than for some other forms of car finance
  • Because you own the car outright, you’ll be responsible for all repairs and servicing
  • If you sell the car, you’ll still need to pay off the loan

What do I need to get car finance?

When applying for car finance, it’s important to have all your documents in order. You’ll need proof of address (which could take the form of a council tax or utility bill), a valid form of ID such as a driving license or passport, and some lenders will also want to see proof of income. A few months’ worth of payslips will usually suffice.

How are interest rate rises affecting car finance?

Rising interest rates are inevitably driving up the cost of financing a car, meaning you end up paying back more over your agreement. In addition to this, you’ll notice fewer 0% finance deals offered than there were previously. The criteria around loan approval may also become more stringent, with applicants needing higher credit scores and a higher income.

Which type of car finance is right for me?

This will really depend on your current situation, however there should be a type of finance to suit you. If you don’t want to have to worry about the cost of depreciation, and don’t plan on keeping the car at the end of the agreement, then PCP finance will suit you.

However, if you want to keep the car at the end, and don’t want to worry about mileage limits or paying for potential damage, then a Hire Purchase agreement could be a better option. Personal contract hire will allow you to change cars more frequently, and you may get a lower monthly price as well.

Personal loans are your only real option if you plan to buy a car from a private seller. They also give you the freedom to do whatever you want with the car as you own it from day one.

Car finance FAQs

Can I end my car finance agreement early?

This depends on what type of finance you’ve taken out. With a PCP agreement, you have to have paid off 50% of the loan amount before you can end it. If you’ve not paid 50%, you’ll have to pay the difference before you can end your contract.

If you’ve gone for a leasing deal, ending the agreement early can be somewhat more tricky. Some contracts will require that you pay off the entire outstanding balance before cancelling, whereas some will ask for 50% of any outstanding rental. Some providers will allow you to switch vehicles, however this isn’t a guarantee. Check the details of your contract carefully before trying to cancel.

Under the Consumer Credit Act 1974, borrowers can ‘voluntarily terminate’ a HP agreement once 50% of the loan has been paid off. If you’re struggling with your repayments, this may be the route you choose to go. Keep in mind that the car will need to be in good condition when it’s returned, and you may be liable to pay for any repairs.

If you want to end a personal loan early, you’ll been to ask the lender for a settlement figure. They will then give you a figure that you need to pay in order to end your repayments. This will be the amount you owe plus an early settlement charge, if applicable. Under the Consumer Credit Act, lenders are able to demand up to two months’ interest as an early settlement charge.

Can I get car finance with bad credit?

Technically yes. There’s no minimum credit score to get car finance, however a poor rating will make you seem a higher risk to lenders and they are therefore less likely to accept you. You may also find that the interest rates increase for those with a poor credit score, so be careful when applying and only take out a loan if you are certain you can pay it off. Remember that buying in cash is always an option.

Can I sell my car with outstanding car finance?

It is illegal to sell a car with outstanding finance, as you don’t technically own it until you’ve paid it off. If you want to sell your car with finance outstanding, you’ll need to pay it off first. Most dealers can settle the finance for you when you trade the car in. So say, for example, your car is worth £10,000 and you owe £5,000, the dealer will pay off the £5,000 and you’ll get the remaining £5,000 back.

Can every dealer on carwow provide finance offers?

All dealers on carwow are official UK main dealers. This means they can all provide manufacturer-backed finance offers. They can give you a personalised quote depending on what size deposit you’d like to pay, how long you’d like to keep the car and how many miles you’d like to cover each year.

Can I take advantage of manufacturer offers when I buy a car through carwow?

You can. Manufacturers may offer further discounts in the form of deposit contributions and low interest rates on some models. Any finance offer you receive from carwow will show applicable finance deposit contributions and APR interest rates. Extra discounts, including manufacturer loyalty schemes, can be added to your existing offer.

Do all manufacturers offer finance packages on their cars?

Yes. All manufacturers provide ways to finance their cars if you’ve decided paying in cash isn’t for you. Some may outsource the deal to a third-party finance house, while other car companies may have their own in-house bank.

I own my own business – can I take advantage of business rates through carwow?

Yes, you can. When you receive finance offers through carwow, it’s worth notifying the dealers if you’re a business owner or a sole trader – you may be offered different funding options to a private buyer.

Is there anything else I should look out for?

Some dealers may also offer sizeable discounts that are, in fact, manufacturer finance incentives – available from any main dealer. If you buy a new car through carwow, you’ll be able to take advantage of both manufacturer deals and individual dealer offers.

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