How Does Car Finance Work? Types, Benefits & Risks

Buying a car is probably one of the biggest purchases you’ll ever make. But what if you can’t afford the upfront cost or would rather spread it out in monthly payments? In that case, car finance could be right for you.

Read on to learn how financing a car works, the options available to you and how much it’s likely to cost.

What is car finance?

Car finance is a general term referring to various options that allow you to borrow money for a second-hand or new car or lease a vehicle for a while before having the option to buy it.

How does car finance work?

Financing a car involves entering into a credit agreement between you and a lender with interest payable on the loan balance. You’ll usually pay a non-refundable deposit and regular instalments throughout your contract.

It’s also possible to get a finance contract without a deposit, but you have to pay more money back through higher monthly instalments and interest.

When you reach the end of your contract, depending on the type of finance agreement, you’ll either:

• Have bought the car outright

• Have the option to buy it

• Return it to the dealership

The contract terms may require you to stick to a service plan or stay within an agreed annual mileage.

What are the different types of car finance?

Hire Purchase (HP)

With a hire purchase agreement, you pay an initial deposit and make fixed monthly payments. Typically, the deposit is around 10% - the more you pay upfront, the better your finance agreement will be. You get to choose the length of the repayment period (usually up to five years), and when you finish all the payments, the car belongs to you.

Benefits of HP

• Doesn’t usually have mileage restrictions

• Some lenders offer HP finance options for applicants with a poor credit history

• You’ll legally own the car when you finish making your finance payments

• You don’t need to worry about being charged for damaging the vehicle (unless you terminate the contract early)

Disadvantages of HP

• You’ve committed to buying the car using this finance option; you’ll have to terminate early to give the vehicle back

• You need permission to sell or modify the car until you finish paying the total balance, at which point you become the legal owner and can do what you want with it

• Your finance payments are likely to be higher than PCP

• You’ll need to pay an initial deposit

Personal Contract Purchase (PCP)

If you take out a PCP contract, you pay a small deposit and receive a loan at the start to cover the car's depreciation during the contract. Depreciation means how much value the car will lose.

After this, you make monthly payments with interest over the agreed term. At the end, you decide whether to trade the car in and start a new PCP contract, give the vehicle back to the dealer, or make a final balloon payment to keep the car.

Benefits of PCP

• Monthly payments are typically lower than other types of finance

• You can choose flexible repayment terms

• You can select a payment plan that suits your budget

• You have the option to hand back your car at the end of the contract

Disadvantages of PCP

• You don't legally own the car until you finish the monthly payments and the final balloon payment, so you can't sell or modify the vehicle without the lender's permission

• If you damage the vehicle, you will be charged for repairs

• You'll have to pay extra mileage fees if you go over the agreed mileage

• You'll end up paying more than the cost of the car because of interest

Personal contract hire (PCH)

Personal contract hire is also known as leasing. It allows you to hire a car for a few years and return it at the end of the lease period. You usually pay a non-refundable deposit and monthly repayments to cover the cost of the car’s depreciation, and you have to follow a service plan and keep it in good condition to avoid fines. 

At the end of the agreement, you don’t own the vehicle and don’t have the option to buy it. However, leasing allows you to change your car every two to three years easily.

Benefits of PCH

• Gives you access to a new car for a lower amount compared to other finance options

• No commitment is required other than your monthly payments

• The terms of the contract are flexible - you choose the length of the contract and how much to pay upfront

Disadvantages of PCH

• You don’t get to keep the car at the end

• You will be charged for damaging the car

• You will be charged for going over the agreed mileage

• You can’t end the contract early, even if your financial circumstances change

Personal loan

A personal loan is one of the most popular ways to finance a new car. You borrow money to fund the purchase, often from a bank or building society, and buy the vehicle outright. You then pay the money back to the lender in instalments with interest over a period that suits you.

The interest rate will vary from lender to lender and often depends on your credit score and the loan duration. If you don’t want to change cars often, funding your next one with a loan could be a good option. 

Benefits of a personal loan

• You own the car straight away and can do whatever you want with it

• You don’t need to worry about damage charges or excess mileage

• There’s no deposit or final balloon payment to consider

• You could end up paying less overall if you find a loan with a reasonable interest rate

Disadvantages of a personal loan

• You don’t have the option to hand back the car at the end of your contract

• You might not be eligible for the advertised interest rate even with a good credit score

• You might have to wait for the money to come through, depending on the lender

Which finance option is right for me?

Use the following questions to help guide you through the decision-making process:

• How strong is your credit score? You’ll be eligible for more deals at better rates with a good credit score.

• Do you want a new or used car? Finance options will be different if you choose a second-hand vehicle.

• Do you want to own your car outright? A personal loan allows you to own the vehicle from day one, whereas a hire purchase contract must be paid in full before you are the vehicle’s legal owner.

• Will you want to sell the car at the end of the contract? Hire purchases and loans often work best if so.

• How will you use your car? Some options, including PCH, often have mileage limits.

• How much of a deposit can you afford? Some finance companies offer no-deposit deals.

• What type of car do you want? Prices will likely differ depending on whether you want a manual or an automatic.

How much will car finance cost?

The cost of financing a car includes a deposit, monthly instalments and a final payment if you choose to keep the vehicle at the end of the contract. There could be additional charges if you have to pay for servicing, road tax or going over the agreed mileage.

Factors that will affect the cost of your agreement include:

• The type of car

• The size of your deposit

• The length of the contract

• The size of the final payment

Is car finance a good idea?

If you’re sure that you can manage the payments without missing them or being late, finance is an excellent way to break up the upfront cost of buying a car into smaller chunks spread over a longer period. However, there are some risks involved that it’s important to acknowledge.

The risks

• Monthly payments can be expensive

• If you default on payments, you could lose your car and seriously damage your credit score

• The vehicle’s value depreciates while you’re still paying

• You are stuck with the same car for the duration of the finance agreement

How to get the best car finance deal

Here are our top tips to help you secure the best possible deal:

• Know what you can afford and budget accordingly

• Look closely at the terms and conditions so you know what’s required and what happens if you miss a payment

• Compare finance agreements and check how changing the type of car, contract length, and deposit size affects the price

• Find multiple quotes, as you can use these to haggle

• Take your time researching to find the perfect deal - it’s your car and your money, so it’s vital to get the right one

How to apply for HP and PCP finance

• When you’ve chosen the car you want, use a finance calculator to get a quote. You’ll need to put down a deposit that will determine how much your monthly payments cost.

• Once you’ve found a quote you’re happy with, you can apply online by providing details such as your address history.

• Lenders will review your application to check that the finance agreement is affordable.

• If your application is approved, you’ll receive your car finance offer and can get on the road.

• You will pay instalments each month on the contract's agreed-upon date.

Can I get car finance with a bad credit score?

Finance companies will consider your credit history and score when deciding whether to lend to you. If your credit score is low because you’ve struggled with debt before, you’ll likely be charged a higher interest rate and won’t be offered the best deals.

Although you might not get a great deal, getting a finance contract is still possible. Some companies specialise in car finance for drivers with bad credit. However, you should consider whether you can afford it before taking out a contract.

What happens at the end of the finance term?

What happens at the end of your contract depends on the type of finance agreement you’ve taken out.

• Hire purchase - you own the car after the final payment.

• Personal contract purchase - you can make a final balloon payment to buy the vehicle or return it and walk away.

• Personal contract hire - you return the vehicle at the end of the contract and either walk away or take out a new lease.

Can I end my car finance contract early?

It’s usually possible to pay your PCP or HP finance early, or you can voluntarily terminate your contract if you’ve paid more than 50%. At that point, you can return the car and stop paying. The termination will appear on your credit record, but it shouldn’t stop you from being eligible for future credit. However, finance providers may be more hesitant to lend to you in the future.

Frequently asked questions

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