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How car finance works

Understand the options for funding your car

With so many finance choices available, thinking about how you’ll pay for that new set of wheels can be confusing. Our guide explains car finance so you can decide which option is right for you...

By Lucy Hancock

Published: 09 July 2021

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Funding a new car can be expensive, especially if you choose to pay upfront. But if you don’t have the cash saved to buy the car outright, there are several finance options available. That’s where car finance comes in. By using credit you can make your new wheels feel more affordable by spreading the cost into repayments.

What is car finance?

Car finance is a catch-all term for a range of options that allow you to borrow the money you need to buy a new or second-hand car, or lease it for a period before having the option to buy it outright.

You only need car finance when you don’t have enough cash to pay the full price for the car you want.

There are several ways to finance a car purchase and they work in different ways, including:

  • Car loan: You ask a loan provider to lend you enough money and then pay the lender back in monthly instalments over an agreed period, with pre-agreed interest added
  • Hire purchase (HP): You’ll make monthly payments to a car finance company. The difference is that you’re technically paying to hire the car – and you’ll only own the vehicle after the final payment
  • Personal contract purchase (PCP): You should have lower monthly repayments because you’re only paying a portion of the car’s value. You have the option to make a higher final payment at the end of the contract to keep the car, or you can return it and take out a new arrangement on a different car
  • Credit cards: You might choose to use a credit card to fund your car as long as the dealership allows. This is usually only a wise option if you have access to a card that has a long interest-free period on purchases, as cards will typically have high rates of interest

How does buying a car on finance work?

While most car finance options will see you borrowing money from a lender to fund a new car, they all work in different ways. With this in mind, it’s important that you consider the ins and outs of each car finance option before going ahead with your choice.

You should be able to use any of these options to buy either a new car or one that’s been pre-owned, but always check with the dealer and the lender first.

How using a loan to buy a car works

If you can’t afford to buy a car outright, a car loan can be a cheaper way to borrow than other types of car finance. Using a loan to buy a car works like this...

  1. You’ll choose the amount you need to borrow and how long you want to borrow it for (the term) - it’s often a cheaper option in terms of interest charged
  2. If your loan is accepted, the bank will pay the money directly to your bank account so you can buy the car
  3. From there, you’ll pay off the loan instalments back to the provider

Loans can be arranged quickly online through price comparison websites like MoneySuperMarket, or by phone, subject to credit checks. The better your credit score the better the rate you’ll be offered.

How PCP works

PCP can work out cheap at the outset, compared to other types of car finance, but it can prove more expensive overall if you want to own the car at the end of the contract. Here are the key features:

  • You take out a loan at the start, but it doesn’t cover the full cost of the new car. Instead, it'll cover the depreciation of the car – that is, how much the lender thinks the car will fall in value compared to its value brand new
  • Pay a small deposit (typically 10%) and make monthly repayments with interest – the term of the PCP will usually range from one year to four years
  • At the end of the contract, you have three options: trade the car in and start a new PCP, give the car back to the dealer and walk away, or make one final payment to keep the car (known as a balloon payment) – you pay what the car is currently worth
  • The balloon payment at the end can be expensive, especially if the car has held its value
  • If you go over the agreed mileage or the car has a lot of wear and tear at the end, you’ll have to pay extra

How HP works

Hire purchase arrangements often cost you less up front, but they come with drawbacks. This is what you need to know:

  • Under a hire purchase agreement you make monthly repayments to hire the car – this includes the loan and interest
  • You don’t own the car until you make the final payment
  • Hire purchases are offered directly by the dealership, so they’re normally easy to arrange
  • They require a deposit of at least 10%, but your terms will usually be better the bigger the deposit you can put down
  • Choose the length of repayment period you prefer, usually up to five years
  • Shorter-term hire purchases tend to be more expensive

Buying a car on a credit card

Credit cards are another way to finance your new wheels. Using a credit card to buy a car works best as part of a cash purchase – if you buy a car entirely on credit, your repayments are likely to end up very high.

  • The most affordable credit card to use is a 0%-interest purchase credit card. These cards generally have decent interest-free periods
  • Once the interest-free period ends your card rate is likely to spike up so you’ll need to switch to another 0% card where possible
  • If you make part of your purchase on a credit card, there are legal protections which will help you if anything goes wrong
  • You are protected up to a limit of £30,000, but the amount you’re actually able to spend will depend on the credit limit you’ve agreed with the card supplier. Be aware the dealer may not allow you to put this much onto a card as they get charged a 0.3% fee by their banks when you use one, which they can’t charge you for

Leasing your car

Another car finance option would be to lease your car using car finance. This means you hire a new car for several years, returning it at the end of the lease period (essentially a long-term car rental).

Like other hire purchase agreements, you’ll put a deposit down and make monthly repayments. You’ll also be able to add servicing plans to your deal – for an add-on cost, to ensure you hand the car back in good condition and avoid paying fines. The main difference is you won’t end up owning the car at the end of the deal and there is no opportunity to regain some of what you’ve spent on the car by reselling it (which you can do with a car loan, or PCP or HP if you pay for the car at the end of the deal).

Should I buy a car with cash?

If you can afford to, it can be better to buy a car with your own money. Borrowing money (whether that be a loan, PCP or HP) will cost you more in the long run through interest payments. If you don’t have all the money, it’s worth saving as much as you can for the same reason. The smaller the loan you take out, or the larger the deposit you can put down, the less you’ll pay overall.

One thing to consider however is the protection that comes from buying a car through PCP for example. Usually, you’ll be able to take the car back to the dealer if it’s faulty, with free repairs and servicing sometimes part of the deal. Make sure you check the small print of your car finance deal and what protection you’re entitled to beforehand.

How does 0% car finance work?

A 0% APR finance deal means you’ll spread the cost of the car over a set period, making monthly repayments - but without being charged interest on top. You’ll essentially take out an interest-free loan. Dealerships and showrooms typically offer 0% finance, but it may mean you have less bargaining power on the purchase price of the vehicle. Do bear in mind that providers may look to make money elsewhere through other costs and fees, so the overall cost over the term is the same as it would be with interest added. You’ll usually need a strong credit history and rating to be approved.

What happens at the end of the deal?

What happens at the end of your car finance deal will depend on the type of car finance you have and the terms of the deal.

With hire purchase, you’re technically paying to hire the car and you’ll only own it after you’ve made the final payment (with any ‘option to purchase’ fees added on top).

 

Personal contract purchase (PCP) will give you the option to make a large final payment (known as a ‘balloon payment’) to keep the car, or you can return it and walk away, or take out a fresh PCP on a new set of wheels.

If you’re looking to own the vehicle straight away, taking out a personal loan may be your best car finance option. This way, you’ll own the car outright as you’ll use the proceeds of your loan advance to buy the car. You’ll then pay back the loan in monthly repayments to the lender – with interest added. Unlike HP or PCP, there’ll be no extra fees or charges to pay on top of the loan.

Can I get car finance with bad credit?

If you don’t have a credit history or have struggled with debt in the past leaving you with bad credit, you may be wondering what your options are when it comes to car finance.

When deciding whether to offer you a car loan, lenders will look at your credit score and how you’ve managed credit in the past. To put it simply, if your financial history is in good shape, you’ll have access to a greater choice of deals and lower interest rates. The same can apply for PCP and HP, where dealers may look at your credit history before accepting you for a deal.

That said, bad credit doesn’t have to be an instant ‘no’ when it comes to car finance. Here at MoneySuperMarket we work with specialists in car finance for bad credit, and may be able to match you with the right car loan.

Is it worth getting a car on finance?

Whether getting a car on finance is the right choice for you will depend on your personal, financial circumstances including your credit history. As with a loan, PCP and HP mean you’re borrowing money which needs to be paid back – so you’ll need to make sure you can afford to meet your repayments.

Buying a car through PCP or HP is a popular option, mostly because it makes financing a new car more affordable. Car finance lets you pay off your new wheels over a number of years and as long as you work out what you can afford to pay repayments wise, you’re likely to have a wider choice of cars to pick from than you would buying the car outright with cash.

Unsure about whether to take out a loan for your car? Our car loan calculator can give you a good idea of how much your loan will cost you, factoring in APR and the length of term to work out how much you’ll need to repay.

Compare car finance with MoneySuperMarket

MoneySuperMarket works with a wide range of personal loan providers. If you want to finance a car purchase, you can compare loans and sort them by size, duration and interest rate to find the right loan for your needs.

All you'll need to do is provide a few details about yourself, and from there we’ll perform what’s known as a soft credit check, which won’t harm your credit score. You’ll then be shown which loans you are most likely to be accepted for. This puts you in control before you apply for a loan.

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