Car finance explained: how does it work?

Car finance can be confusing and full of jargon. But it can also help you get a great deal on your next car. Find out how it works

BuyaCar team
Jun 30, 2021

Asking a car salesperson about car finance will almost inevitably mean a response peppered with confusing-sounding abbreviations like PCP, GMFV, HP and APR. But what do they all mean? Feeling pressured and confused by a car dealer could mean you sign up to a form of finance that isn’t right for you. But the reality is not that complicated if you do a little bit of preparation to understand your options.

So getting to grips with the various types of car finance and the terminology associated with them is useful before you sign on the dotted line, especially as different finance methods will work for drivers with different circumstances.

For example, if you want to ensure low monthly payments, but still want the option to buy the car at the end of the contract or hand it back, Personal Contract Purchase (PCP) finance could well be the right move for you.

However, if the lowest overall cost to buy the car is your main aim, then Hire Purchase (HP) could suit you. And if you simply want the lowest monthly payments and don't want the option to own the car, you may want to look into leasing, also known as Personal Contract Hire (PCH).

This back-to-basics guide will explain in simple terms how car finance works and the differences between the multiple payment options, so you can be sure which type of finance is best for you.

Once you’re happy with the basics, then you can explore your finance options further, with more detailed articles about the car finance options available to you, or you can click on the buttons above to search for the latest finance deals across thousands of cars, get your head around no-deposit deals or search for the best used cars for £100 per month.

What is car finance?

Finance helps to make cars more affordable by spreading the cost across a deposit and a series of monthly payments. This means you can effectively borrow money to pay for a car and then repay this in instalments to the finance company.

One form of traditional car finance - known as Hire Purchase (HP) - works a bit like a bank loan. This means you can purchase a new or used car without having to save until you have enough cash to buy it outright. You simply pay the deposit, followed by a series of equal monthly payments and then once you've made the last one of these, the car is yours. You can keep it, sell it or part exchange it for a new model.

Meanwhile, another option - Personal Contract Purchase (PCP) finance - involves a deposit, and then a series of monthly payments that are lower than with an equivalent Hire Purchase setup, so you can afford to get a newer or more desirable model for your monthly budget.

The reason for this, is that the deposit and monthly payments don't cover the full value of the car with PCP (as is the case with Hire Purchase), as you have to make a large optional final payment (which is set before you sign the deal) at the end of the contract if you want to take ownership of the car.

If you don't want to pay this - or can't afford to - you can either hand the car back to the finance company with nothing left to pay (provided you've stuck to the pre-agreed mileage limit and kept the car in good condition), or you can refinance the optional final payment with a further series of monthly payments.

In most cases, lenders charge interest for providing finance (the exception is with 0% APR deals, which are sometimes available on new cars). The amount of interest that you pay increases with the amount you borrow and length of the finance agreement. So, the more you borrow and the longer the contract, the more interest you'll end up paying.

It's also worth being aware that if you intend to buy the car at the end of a PCP finance contract, you're likely to have to pay more in interest than you would with an equivalent Hire Purchase deal. That's because with Hire Purchase you pay off the finance balance quicker, so less interest builds up.

Who provides car finance?

Specialist lenders supply car finance. Some of these are part of a car company itself, while others form part of a bank or another financial institution.

These companies work with manufacturers and retailers help drivers fund their next vehicle. When you successfully apply for finance, the car is sold to the finance company and delivered to you. You then make payments to the lender.

Car finance payments

Deposit

The deposit is an upfront payment made before you receive the car. This goes towards the cost of the vehicle and therefore you don't ever get it back. You may have the option of paying no deposit, but be aware that the smaller the deposit you put down, the higher your monthly payments and the more interest you'll pay (except where interest-free credit - also known as 0% APR - is available, as no interest is charged then).

For example, if you choose a £10,000 car and put down a £1,000 deposit, you’ll owe £9,000. Meanwhile, if you increase the deposit to £2,000 that would reduce how much you owe to £8,000, which in turn would shrink down your monthly payments and the amount of interest you pay, as you're borrowing less.

Monthly payments

Once you've paid a deposit - or not, if you go for a zero deposit option - you then make a series of monthly payments for the length of the contract, which go towards the cost of the car and include a little interest. These are usually spread over two to five years, depending on the type of finance you go for.

Payments have to be made in full and on time, or you risk having the car taken back by the lender. If you encounter financial difficulties, or expect that you will in the near future, it's best to flag this as soon as possible with the finance company as they may be able to help - potentially by reducing your payments for a couple of months or lengthening the contract to lower your instalments, for instance.

It's important to understand that 'defaulting' - missing any of your payments - can seriously affect your credit score, making it more difficult and more expensive to get finance in future, so it's wise to try not to overstretch yourself. However, if you do have a low credit score, check out our roundup of the best bad credit finance deals, to make sure you're getting the most for your money.

What happens at the end of a car finance contract?

Sign up for a Hire Purchase deal and once all of your payments have been made, you then own the car and you're free to keep it, sell it or part exchange it for a new car. With PCP finance, however, you don't own the car unless you make all of the monthly payments, plus the optional final payment.

The optional final payment - also known as the balloon payment - is a pre-agreed figure that roughly equals what the car is expected to be worth at the end of the PCP deal. If you want to own the car, you have to pay this - or you can take out a new finance contract to cover the cost of this. Alternatively, you can hand the car back with nothing left to pay, provided it's in good condition and you've stuck to the mileage limit agreed at the start of the contract.

Read our guide to what happens at the end of a PCP finance contract to understand all of your options, as you can also consider trading it in and using any value in the car over the remaining finance balance to put towards your next car.

Car deals under £200 per month

What types of car finance are there?

Different types of car finance have developed to suit a range of budgets and circumstances. These are the most popular types, which cater for those who want to own the car at the end of the contract for the lowest overall cost, those who want low monthly payments with the choice to buy the car when the contract ends and those simply after the lowest monthly payments with a plan to hand the car back and move to a new one at the end of the contract.

Hire Purchase (HP) / Conditional Sale

Hire Purchase - also known as Conditional Sale - is the most straightforward type of car finance and is available for virtually any new or used car. It works well for drivers who want to own the car for the lowest total cost.

The cost of the car, minus any deposit you make, is split into a series of equal monthly payments, which include interest.

Once you’ve made all of the payments, you will own the car and you're free to sell it, to part exchange or you can simply keep driving it with no further monthly payments. More details

How HP finance works

1. Deposit and delivery

  • Place a deposit to reduce how much you owe
  • In some cases zero-deposit options are available

2. Monthly payments

  • Pay for the rest of the car with a series of fixed monthly instalments

3. You own the car

  • Once you've made the final payment, the car is yours and you can keep it or sell it

Personal Contract Purchase (PCP)

This is the most popular type of car finance because it combines low monthly payments with the flexibility to buy the car or hand it back at the end of the contract.

Drivers typically pay a deposit - the larger this is, the lower your monthly payments and the less interest you'll have to pay - though no-deposit options are sometimes available. You’ll then make a series of fixed monthly payments until the end of the agreement.

These payments are lower than with most types of finance because they don’t cover the full cost of the car. Instead, you’re only paying for the value that the car is expected to lose during the finance term.

The lender estimates how much the vehicle will be worth at the end of the agreement and then works out the difference between this future value and its current price. Your monthly payments, minus any deposit, will cover this difference, with a little interest included.

Part of this process involves setting an annual mileage limit. The higher the mileage allowance, the higher your monthly payments, though be aware that you if you exceed this and then hand the car back at the end of the contract, you can expect to be issued with a per-mile charge.

It's best to go for a slightly higher mileage allowance than you expect to cover and to ask the lender to increase the limit during the contract if you think you're going to go over. Meanwhile, if you make the optional final payment to buy the car, the mileage of the car is not relevant, as you'll own it once this payment has been made.

At the end of a PCP finance contract you have several options:

  • Return the car to the lender. You’ll face penalty fees if there is damage beyond what's classed as fair wear and tear, or if you have gone over the mileage limit.
  • Buy the car by making the optional final payment (also known as the ballon payment, guaranteed minimum future value, or GMFV). If you can’t afford to pay the full amount in one go, this can be refinanced, spreading the cost over another series of monthly payments.
  • If your car turns out to be worth more than its optional final payment, then you’ll also be able to trade it in for another model with most car retailers. They will pay off your finance, and put the amount over the finance balance towards the deposit on another car, reducing your monthly payments.
  • You could also sell the car with the agreement of the lender and pocket any difference over the optional final payment, or the settlement figure if you do this before the end of the contract. More details

How PCP finance works

1. Deposit & delivery
  • The larger the deposit, the lower your monthly payments
  • A no-deposit option is often available
2. Monthly payments
  • A fixed payment is due every month for the rest of the agreement
  • You only repay part of the car's cost, keeping monthly payments low
3. Buy / return / upgrade
  • Pay the remaining balance or refinance to keep the car
  • OR Return the car with nothing to pay
  • OR Trade-in for another vehicle if the car is worth enough

Leasing or Personal Contract Hire (PCH)

Leasing isn’t strictly car finance because you're not actually borrowing money. It's more like a long-term car rental contract - you pay for use of the car for a set period of time.

You’ll pay an initial rental fee, which you don’t get back - this is the similar to the deposit that most people with PCP and Hire Purchase deals pay - followed by fixed monthly payments.

At the end of the agreement, you return the car and there’s no option to keep it. A mileage limit applies to lease agreements, and since you have to hand the car back at the end of the contract, you will face penalty fees if you go over this limit or if there is any damage beyond fair wear and tear. More details

How car leasing works

1. Initial payment

  • Initial payment is usually the equivalent of 3 to 12 monthly payments

2. Monthly payments

  • Fixed monthly payments throughout the agreement

3. Return the car

  • Once all payments are made, you return the car.

How is car finance interest calculated?

The interest that you pay on car finance is calculated as a proportion of the amount that you borrow. The higher the interest rate and the greater the amount you borrow, the more you’ll be charged in interest.

As you repay your finance, your remaining debt will decrease, and so will the amount of interest remaining to pay. This is why it’s cheaper in the long run to pay your finance off quickly. It's also why interest charges are lower with Hire Purchase than PCP; Hire Purchase monthly payments are larger, so you're paying off the finance balance quicker.

The interest rate that you’re offered will depend on the value of the car that you’re financing and your personal circumstances. If you have a history of repaying debt on time and are in a stable situation, with a steady job, then lenders should assume that you’re likely to repay the finance in full and offer you a lower rate.

Borrowers who have a history of money troubles usually have to pay a higher interest rate, as lenders assume that there’s a higher risk that they won’t meet their repayments or will make payments late.

Comparing car finance

Monthly finance payments include the cost of interest, as well as additional fees imposed by lenders.

That’s why every car finance agreement must include an Annual Percentage Rate (APR) figure. This takes into account all fees and interest, and converts them into a standardised number that can be used to compare quotes.

Because every APR figure is calculated in the same way, you can be confident that the quote with the lowest number will be the cheapest form of finance. Be aware that as leases are a rental product, rather than a finance product, they do not have an APR figure as Hire Purchase and PCP finance deals do.

It’s also worth looking at the total amount payable, which should be included with every finance quote. This adds up the deposit, monthly payments and interest charges so you can see the cost of extending an agreement from two to three years, for example.

Do bear in mind, however, that any deposit contribution finance discounts that may be available are not normally taken into account in these figures, so you may need to subtract any available deposit contribution from the total amount payable.

 

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