What is car finance and how does it work?

At first glance, car finance can look complicated.
 
With so many different types of loan available and a sea of acronyms to navigate, it can feel like a bit of a minefield.
 
That’s where we come in.
 
We’re here to help you guide you through the process, cut through the jargon, and give you all the details you need to make an informed decision that’s right for you.

What is car finance?

Car finance is an umbrella term used to describe borrowing money from a lender to buy a new or used car.
 
This typically comes with a legally binding contract, lasting between one and six years, and set terms and conditions.
 
Throughout the agreement, you’ll make fixed monthly payments to repay the loan plus interest.
 
Car finance comes in many different shapes and sizes and there’s a deal available to suit almost any driver.
 
No matter your financial circumstances, driving habits, and personal preferences, we’ll help you weigh up your options and give you all the facts to help make the best choice for you.

How does car finance work?

No matter whether you choose a Hire Purchase (HP), Personal Contract Purchase (PCP), or any other type of finance, they all work in similar ways.
 
You’ll make a formal agreement with a lender to borrow money so you can buy – or have exclusive use – of a new or used car.
 
Eligibility criteria will usually apply and not every lender will agree to lend to every borrower. They each take different factors into consideration including your credit score, payment history, affordability, the amount you want to borrow, and your preferred loan term.
 
If you’re approved for a loan, the first step is usually a deposit – around 10% of the car’s purchase price is standard.
 
No savings pot? No problem! No deposit loans are also available, albeit with typically slightly higher interest rates attached.
 
Most car finance agreements will last between one and six years and you’ll make a fixed payment each month that includes any interest owed.
 
Terms and conditions will usually apply. Depending on the type of finance, you might need to agree to an annual mileage limit or face extra charges if you return the car with damage beyond fair wear and tear.

Choosing a car finance option

Let’s take a quick look at the different types of car finance on offer:

Hire Purchase (HP)

Hire Purchase – or HP for short – is one of the most popular ways to finance a car purchase. You’ll typically put down a deposit upfront and then pay back the loan in fixed monthly repayments for between one and six years:

• At the end of an HP loan, assuming you've made all your repayments, you’ll pay a small Option to Purchase admin fee to become the car’s legal owner.
• HP loans can have higher monthly repayments as they lead to car ownership, but you won’t usually have to worry about an annual mileage limit.
• During the loan term, the lender will be the car’s legal owner so you can’t make any modifications or sell the car.
• HP finance can be more accessible to borrowers with less than perfect credit scores.

Personal Contract Purchase (PCP)

Personal Contract Purchase – also known as PCP – gives you options. Like HP, you’ll pay a deposit upfront and then make fixed monthly repayments for a set period. But PCP doesn’t have to lead to car ownership:

• When your PCP loan ends, you can make a large one-off payment to buy the car (known as the balloon payment), hand it back to the lender, or use any positive equity available as a deposit in a new deal.
• Instead of borrowing the car’s full purchase price, your loan payments will cover the difference between its current price and how much it’s estimated it’ll be worth at the end of your agreement (its Guaranteed Minimum Future Value or GMFV).
• PCP can have lower monthly repayments than HP, but you’ll have to pay a large one-off balloon payment, usually equivalent to the GMFV, to become the car’s legal owner.
• An annual mileage limit will likely apply, and you’ll face an extra charge for every mile you go over it. 

Personal loan

Personal loans are a different beast as they (usually) aren’t secured against the vehicle. Instead, you’ll become the car’s legal owner as soon as you’ve used the loan to pay the dealer or private seller:

• As its legal owner, you’re free to sell the car, go on a cross-country road trip, add a new set of alloys, or install an upgraded sound system if you like. You just need to make sure you keep making loan repayments until the agreement ends.
• Unsecured loans present more of a risk to lenders, so they’re usually restricted to people with a strong payment history and good credit score.
• Monthly payments can be higher than other finance options.

Personal Contract Hire (PCH)

Personal Contract Hire – also known as PCH or leasing – is a lot like a long-term car rental and rarely ends in car ownership.

• Lease agreements usually last between two and four years and you’ll pay a fixed monthly payment during this time.
• You’ll typically need to hand the car back at the end of your lease.
• An upfront deposit is usually required.
• You’ll likely have to agree to an annual mileage limit and keep the vehicle in good condition to avoid extra charges.

Car subscriptions

Car subscriptions are a more recent addition to the car finance market and are ideal for those who would like access to a car without the commitment of a fixed-term lease.

• You’ll usually agree to a flexible month-by-month subscription and pay a fixed regular payment in return.
• Car subscriptions are often only offered on brand-new cars so can be a good way of getting behind the wheel of the latest models.
• Subscriptions can be more expensive than a longer-term lease and the amount you pay will typically include all your incidental costs. The only added extra you’ll need to cover will be the fuel you use.

How much will car finance cost me?

The cost of car finance is typically made up of:

• Your deposit – a non-refundable amount that you put down upfront, usually around 10% of the car’s purchase price.
• Your monthly instalments – the amount you need to pay each month to repay the loan plus any interest owed.
• The final payment – depending on the type of car finance, this could be a small Option to Purchase admin fee of up to a couple of hundred pounds or a large one-off balloon payment that could cost thousands.

The higher the interest rate of your loan, the more you’ll need to pay back both monthly and overall.

You may also face extra charges in a PCP or PCH agreement if you return the car and it’s damaged beyond fair wear and tear.

A payment per mile will likely be applied if you’ve exceeded the agreed annual mileage limit too.

What is the best option for me?

There are no hard and fast rules when it comes to choosing a car finance deal; the best option for you will always be the one that fits your budget, individual circumstances, and personal preferences.
 
Here are a few things to consider when making your mind up:

Do you want a new or used car?

Some types of finance, such as PCH and car subscriptions, are typically only available on brand-new cars fresh from the factory floor.

How is your credit score?

If you have a good or excellent credit score, you may be eligible for non-secured finance options like personal loans. In contrast, if you’ve missed payments in the past and need to work on your score, you may be better off with a secured loan like HP.

Is car ownership important to you?

If you dream of being the legal owner of your new pride and joy, you probably won’t want to choose a PCH or subscription deal that requires you return the car at the end of the agreement. This is also a consideration if you would like to have the car as an asset that you can sell in the future.

How do you drive?

A long-distance commuter who spends hours on the motorway each week would likely not be suited to a car loan with an annual mileage restriction, while someone who only uses their vehicle to pop to the shops each week might find it easy to stick to a limit.

Do you have a deposit available?

HP, PCP, and PCH loans typically ask for a deposit to be put down upfront (although no deposit deals are available). If you don’t have any savings ready to go, you might be better suited to a personal loan.

Are low monthly repayments your priority?

When you’re working with a strict budget, nobody would blame you for looking for the lowest possible monthly repayment amount. If this is your priority, then PCP might be a better option than HP.

What happens at the end of my agreement?

Whether you’ve been making payments for two years, four years, or six, once you reach the end of the agreement congratulations are in order!
 
But what happens next?
 
It all depends on the type of finance you have:

End of an HP loan

HP car finance is designed to lead to car ownership. Once all your payments are made, you’ll typically need to make one more cost to cover the admin fee of transferring ownership into your name. This is known as the Option to Purchase fee and usually costs less than £200. Here at Carmoola, our Option to Purchase fee is only £1.
 
As soon as this is all sorted, the car will be all yours!
 
You can then choose to keep it, modify it, sell it, or offer it as a part-exchange – it’s up to you.

End of a PCP loan

PCP loans give you more options at the end of the agreement. You can choose whether to buy the car and become its legal owner, hand it back to the lender, or use any available equity as a deposit for a new car.
 
If you choose to buy the car, you’ll need to pay a one-off balloon payment. This covers the remaining value of the car, also known as its GMFV. Depending on the car’s purchase price and rate of depreciation, this could be several thousand pounds.
 
Ready to return the car instead? Keep in mind that extra charges can apply if you’ve driven over the mileage limit or damaged the car beyond small scratches and scrapes.

End of a PCH term

PCH leases and car subscriptions don’t usually end in car ownership, although this can sometimes be an option.
 
Generally speaking, once you reach the end of the lease term or choose not to renew your subscription, you’ll hand the car back and walk away.

End of a personal loan

The big difference with a personal loan compared to other types of finance is that you’ll be the car’s legal owner as soon as you use the loan to pay the seller.
 
This means you’re free to sell or modify it during the loan term assuming you continue making payments.
 
Once the term ends, the loan will be marked as completed on your credit report.

What are the risks involved in taking out finance?

Car finance is a big commitment; you’re entering a legal binding contract that could require you to make fixed monthly repayments for up to six years.
 
And a lot can change over time; if you lose your job or have a change in circumstances, you might find yourself struggling to make the repayments. This can negatively affect your credit score and lead to you facing debt recovery action, which can make it hard to secure finance again in the future. In some cases, the car could even be repossessed by the lender.

How does the application work?

Completing an online application form is the first step in most car finance journeys.
 
You’ll need to supply some details to help lenders understand what it is you’re looking for and whether they can offer you a suitable loan.
 
A soft credit check will also usually be part of the early application process, but this won’t be visible on your credit report and shouldn’t affect your score.
 
Most applications will ask you to share:

• Your personal details – like your name and date of birth
• Your address – including previous address history for up to three years
• Your employment status – including your income and job title
• How much you’d like to borrow – this can be an estimate if you’ve not found a car