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Guide

How does car finance work?

If you’re trying to get your head around car finance, and you don’t know your balloon payments from your monthly instalments, and your PCPs from your PCHs, let us help you understand them.

Last updated on 30 July 2024 | 0 min read

Most of us will buy a new car on finance, paying for it in instalments rather than finding the cash to buy it outright.
If you’re exploring finance for the first time, or want to remind yourself of your options ahead of your next car, this guide is for you. We help countless drivers buy their new cars on finance every year, and will help you understand everything from the types of finance agreement, to how you can secure the best one for your budget. In this article, we’re starting at the beginning and you’ll learn: • How car finance works • The types of car finance available • How much it could cost • Whether you own a car paid on finance • How your contract could end Here’s your guide to what car finance is and how it works.

How does car finance work?

With car finance you can buy a car by paying in instalments, rather than paying the full price up front.
To buy a car with finance, you’ll borrow money from a lender and pay it back in instalments over an agreed period of time. Car finance is actually an umbrella term for a range of financial products and services. There are several types of finance agreement available, so details can vary, but we’ll cover them here. This money can be borrowed from a bank, car finance lender, or online lender. For them to lend you the money, you will need to be approved for finance. You will have to submit an application form, and they’ll check your credit history to see whether you can pay them back. You can learn about applying for finance here. Once approved for finance, you will sign a contract that explains how much you need to pay back each month, and how much time you have to fully pay the lender back in full. It will also cover how much you'll pay in interest and charges. Contracts may also explain how many miles you can do a year, and when the vehicle needs servicing. At the end of your contract, you’ll either finish paying and own the car, or you’ll have the option to return it depending on the type of finance agreement you chose.

What are the different types of car finance?

There are some key differences between the different types of finance. Crucially, you’ll pay different amounts at different times. Knowing which finance agreement you have can help avoid any unexpected costs.

Hire Purchase (HP):

With Hire Purchase, you make fixed monthly payments over an agreed length of time, usually one to five years. You’ll also pay a deposit at the start of the contract, and will usually pay interest every month too.
Once all payments are made, you will legally own the vehicle. Pros: • You own the vehicle once all payments are complete. • Fixed monthly payments make budgeting easier. • Suitable for those with average to good credit scores. Cons: • Typically, HP agreements have higher interest rates compared to other finance options. • You won’t own the car until you make all the payments, unless you settle any outstanding finance. • The car’s value may decrease over time (called depreciation) but you’ll still be paying off what it was worth when you started – so you could pay more than it ends up being worth. Learn more about Hire Purchase.

Personal Contract Purchase (PCP):

PCP also involves monthly repayments to a lender, but you have more options at the end of the contract. You can return the car, trade it in for a new one, or make a balloon payment to own it outright.
A PCP contract estimates what the car will be worth at the end of the agreement. This is called the Guaranteed Future Value (GFV). You won’t pay the GFV back as you go. Instead, you’ll pay it back in a final balloon payment if you want to own the car. Pros • Monthly payments are typically lower than HP, as you’re not paying the GFV back. • It’s flexible, as you can choose to return, exchange, or purchase the car at the end of the contract. • If the car’s value depreciates less than expected, your car could be worth more than the amount you still owe, meaning you have equity in the vehicle. Cons: • If you want to own the car at the end, you have to make a final balloon payment and this can be quite a lot of money. • You’ll have mileage limits in your contract, and you may have to pay extra if you drive too many miles. • You won’t own the car until you make the final balloon payment, so you won’t be able to sell or modify it unless you get a settlement figure from the finance company and settle the finance. Learn more about Personal Contract Purchase.

Personal Loan:

You could also borrow a fixed amount of money from a bank or lender to purchase the vehicle outright. With a personal loan, you’d own the car from the outset and repay the loan over a specified term.
Pros: • You own the vehicle from the start. • You can choose the loan term and negotiate interest rates. • Unlike PCP, there are no mileage limits. Cons: • Monthly payments may be higher than HP or PCP. • Interest rates can vary depending on your credit score (which also applies to HP and PCP) • Full Responsibility: You're responsible for the car's depreciation value.

Personal Contract Hire (PCH) aka Car Leasing

Car leasing is worth mentioning here, as it’s another way of paying monthly for a car. The difference is that you won’t own the car, and you’ll always return it when your contract ends.
It’s worth exploring if you’re not fussed about owning a car, and can be a good way to drive a new vehicle every couple of years. You can learn more about leasing here.

Which type of finance is best for me?

The best option depends on your current circumstances, including the type of car you want and your monthly budget.
You need to find a finance agreement that you can afford to pay every month, as missing payments can have a negative impact on your credit score and – in a worst case scenario – could lead to the car being repossessed. If you’re not sure what would suit you, ask yourself these questions: • How much can you afford every month? Remember PCP may be cheaper monthly, but you’d have to save up for the final balloon payment. • What type of car do you want? New or used car? Manual or automatic? Electric? Different finance plans could get you closer to affording the car you really want. • How strong is your credit score? Higher credit scores can get you better deals, including 0% finance for some people. • How much will you use the car? The monthly cost could be higher if you choose a high annual mileage but if you choose a mileage limit that’s too low you need to be mindful of what the excess mileage charges are • When do you want to own the car? With HP and PCP, you’d only own the car at the end of the contract so couldn’t sell or modify it without permission. With leasing, you’d never own the car. To help you find the right finance agreement, we can answer a few questions too.

Do I own a car bought on finance?

This depends on the type of finance agreement.
• With HP, you’ll own the car at the end of the contract, once all payments are made. • With PCP, you’ll own the car once you’ve made the final payment at the end of the contract. • With PCH leasing, you never own the car.

What happens at the end of the contract?

Your options at the end of the contract will depend on the finance agreement you opt for.
• PCP: you can make a one large ‘balloon’ payment to purchase the car. Or you can return it and walk away, or start new PCP contract for another car • Hire purchase: you’ll own the car after the final payment has been made. • PCH/leasing: you’ll return the vehicle at the end of the contract or take out a new lease.

How much will car finance cost me?

The final cost will depend on a number of factors, including:
• the type of car you choose • the size of your deposit • how long your contract lasts • the size of a final payment (where it applies) But the monthly payments are only a part of it. You also need to factor in the following: • Interest payments • Other charges, like arrangement fees • Insurance and road tax, if not included in the contract Take your time to compare options. Play around with contract length, deposit size and other factors to find a total cost that works for you.

How long will my finance term last?

Finance agreements tend to last anything between one to five years. This will depend on the lender and the type of finance agreement you choose.
Choosing a longer contract could lower the amount due in monthly payments, but could result in higher interest payments since you’re borrowing the money for longer. Check all the numbers before you commit, to make sure you can afford the full payments.

Will I be accepted for car finance?

Each lender will have different acceptance conditions. They use these to work out whether you’d be able to repay them, and how much they’re willing to lend you.
They tend to look at: • Your credit history – those with a higher credit score are more likely to get accepted and offered better deals • Your income and employment status • Your age, address, and other personal details like your driving history The more criteria you meet, the more likely you are to be accepted. Read the terms and conditions on a lenders site to see what they’re looking for, and whether you’re likely to be approved.

How do I apply for car finance?

When applying for car finance, you’ll need proof of address (e.g. a council tax or 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.
Read our guide to applying for car finance.

Can I get car finance with a bad credit score?

Getting approved for car finance with a bad credit score can be challenging, but it's not impossible. You can explore different finance deals, or work to improve your credit score.
We cover your options in our guide to getting car finance with a bad credit score.

How to get the best car finance deal

Now it’s time to put all this information into practice and find the best car finance deal for you.
First up, make sure you know what you can afford. Make a note of the total cost of finance over the whole contract, including monthly payments, interest rates, fees and charges. Look at the terms and conditions to make sure you know what you need to do and what happens if you miss or fall behind with payments. Compare finance agreements and see how changing the contract length, type of car and size of your deposit could get a better deal. Remember to factor in other costs, like admin fees. Do your research and find multiple quotes. Different dealers may be able to offer you different finance plans, and in any case you can use these different quotes to haggle. Most importantly: take your time. It’s your car and your money, and you deserve the time to explore your options and find the one that works for you. Don’t be pressured into signing anything straight away. Get quotes in writing so you can go away and think about them. Read the terms and conditions and ask any questions you might have.

Learn more about car finance on Auto Trader

Find cars available on finance near you and learn about the types of finance available on our finance hub.