How Does Car Finance Work?
Paying for a car using finance has become commonplace in the UK. Figures from the Society of Motor Manufacturers and Traders (SMMT) revealed that, in 2018, just under 960,000 people bought a new car using finance while a further 1.45 million people used car finance to fund the purchase of a used car.
When you use finance to buy a car, you will need to be aware of your credit score. Whichever method you choose, the lender will need to perform a hard credit check to assess if they're willing to lend you the amount of money you want to buy a car. Your credit score will affect how much you'll be able to borrow and the interest rates you're offered.
Before committing to any car finance deal, you need to be confident that you can afford the monthly repayments as well as the running and maintenance costs associated with owning a car. If you're unsure how much this is likely to be, you can use the car costs calculator from The Money Advice Service.
Car finance can seem confusing because of the range of different options available. We've put together this comprehensive guide to explain how each car finance method works along with the pros and cons.
- How Does PCP Car Finance Work?
- How Does HP Car Finance Work?
- How Does PCH Car Finance Work?
- How Does Financing A Car With A Personal Loan Work?
- How Does Financing A Car With A Credit Card Work?
PCP (Personal Contract Purchase) is the most popular form of car finance and is typically available directly from the dealership you're buying the car from. It's a secured loan which means that the money you're borrowing is tied to the car, so if you miss a monthly payment, the finance company can seize the car.
If you're buying a new car, PCP car finance is usually offered by the manufacturer's own finance company. Used car dealerships will have affiliated finance companies that they work with; however, you can arrange your own PCP agreement through an online broker such as carfinance247.
Essentially, there are three parts to PCP car finance:
- Monthly Payments
- Balloon Payment
Typically, a buyer will put down a sum of money (deposit) at the beginning of the finance agreement. Although it's called a deposit, you won't get the money back later on, it's simply an upfront payment.
Your deposit can be cash or you can use your current car in part exchange, or a combination of both. If you don't have a car to trade in or any cash for a deposit, some dealerships will allow you to start a PCP car finance agreement with no deposit.
After putting the deposit down (if you have one), you will be left to finance the balance. The bigger your deposit, the less money you need to borrow; therefore, the lower your monthly payments will be.
PCP deals are usually available for anywhere between 18 and 48 months. The longer the agreement, the lower your monthly payments will be; however, you will have to pay more interest, making the total cost of the finance more expensive.
With a PCP car finance agreement, your monthly payments are calculated by taking the deposit and Guaranteed Minimum Future Value (GMFV) of the car away from the sale price.
The GMFV is how much the finance company predict the car will be worth at the end of the PCP agreement, taking into consideration factors such as the length of the agreement and the agreed annual mileage. Ultimately, your deposit and monthly payments are paying off the depreciation of the car.
The remaining balance will be evenly split across the term of the agreement with interest. For example, if you put a £1,000 deposit down on a car worth £15,000 and the GMFV was £4,000, the remaining balance would be £10,000. The PCP agreement is for 48 months, so the monthly payments would be £208.34 plus interest.
The balloon payment is what makes a PCP car finance agreement so popular. The GMFV calculated at the beginning of the agreement is deferred until the end to make the monthly payments cheaper.
In order to settle a PCP deal, the balloon payment needs to be paid, either by paying the remaining amount or returning the car. If the market value of the car is less than the GMFV, the finance company takes the loss and it isn't your problem.
WHAT ARE MY OPTIONS AT THE END OF A PCP CAR FINANCE DEAL?
You have three options when you get to the end of your PCP agreement:
- Pay the balloon payment - paying the outstanding balance will mean you become the owner of the car and no longer have to make monthly payments.
- Give the car back - giving the car back to the finance company will settle the finance agreement and you can just walk away. There will be additional charges if the car has exceeded the agreed mileage, needs repairs beyond normal wear and tear or wasn't serviced on time.
- Part exchange the car with a dealer - if the car is worth more than the GMFV, the difference is called equity. By taking it to a dealer to part exchange, you can settle your PCP agreement and use the equity as a deposit towards your next car. Using the previous example, if you were offered £5,000 for the car, the dealer would use £4,000 to settle your finance and you would have £1,000 to use a deposit for a new car.
|Lower monthly payments||Mileage limit|
|Can finance a more expensive car||Can be difficult to get out of early|
|Change your car every 3-4 years||Have to pay the balloon payment to own the car|
HP (Hire Purchase) is the most traditional form of car finance and is fairly easy to understand. The loan is secured against the car, so if you fail to make monthly payments, the finance company can take the car back. Unlike PCP, nothing is deferred until the end of the agreement - there's just the deposit and monthly payments to consider.
While this is less complicated, it also means that your monthly payments will be more expensive because you're paying back the total cost of the car from the beginning.
Your cash deposit, part exchange car or both are deducted from the car's sale price. The remaining balance will be equally split across the term of your agreement in fixed monthly payments. HP deals are normally available for anything between 12 and 60 months.
For example, if you put a £1,000 deposit down on a £15,000 car, the remaining balance would be £14,000. The HP agreement is 48 months, so the monthly payments would be £291.67 plus interest and any fees.
At the end of a HP deal, once you've made the final monthly payment and paid any fees (e.g. transfer of ownership), you will own the car.
|No maximim deposit||Higher monthly payments|
|No mileage limit||Only become the owner once the finance is settled|
|Easy to settle the agreement early|
PCH (Personal Contract Hire) is essentially a rental agreement between you and the finance company. Unlike PCP and HP car finance agreements, you will never own the car.
The principle for a PCH car finance agreement is the same as any other car rental, except that instead of only lasting a few days, they tend to last anywhere between 12 and 48 months.
Typically, PCH is reserved for new cars because it's a leasing agreement and not an ownership product. Buyers can deal with the manufacturer's dedicated contract hire department of their finance company, an independent broker or a specialist finance company.
You will be required to pay an upfront cost often referred to as an initial rental which is usually between 3 and 12 monthly payments. This will be followed by fixed monthly payments for your agreed term.
As part of the agreement there will be a set annual mileage that you need to stick to and the car must be kept in good condition. At the end of a PCH deal, you simply give the car back to the finance company and walk away, unless you've gone over the agreed mileage or the car needs repairs beyond normal wear and tear.
|Low monthly payments||Never own the car|
|Covered by the manufacturer's new car warranty||Mileage limit|
|Greater choice of finance companies||Inflexible contracts that are difficult to end early|
If you don't want to finance a car with any of the dealer finance options above, you can take out an unsecured personal loan from a bank or building society. Most lenders offer terms between 12 and 60 months, but some will allow you to spread payments up to seven years.
Using a personal loan, you can borrow the exact amount that you need to buy the car outright and make monthly repayments to a bank or other lender instead of a traditional car finance company.
This means that you can sell the car at any point - even if you're still repaying the loan - and you can make any modifications you like.
|You own the car||APR rates may be higher|
|No mileage limit||You bear the brunt of the car's depreciation|
|Can make modifications||Any of your assets could be seized if payments aren't made|
It is possible to use a credit card to partly pay for a car or to pay for it in full depending on the price of the car, the credit limit on the card and whether the dealership accepts credit cards.
NOTE: You actually get extra protection on the full purchase cost when you pay with a credit card as long as the car is worth more than £100 but less than £30,000 and you meet the minimum monthly payments on your credit card.
Using a credit card to buy a car is similar to taking out a personal loan. You can buy the car outright and simply make monthly payments back to the credit card provider.
Unlike any other finance option, the monthly payments are not fixed. As long as you meet the minimum monthly payment, you can choose how much you want to pay each month to suit your circumstances.
In addition, some credit cards offer 0% interest rates on purchases for a set period of time. If you can pay off the car before the 0% period ends, you won't pay any extra.
Financing a car with a credit card is something you should only consider if you know exactly what you're doing when it comes to balance transfers and the expiration of introductory interest rates on purchases.
|You own the car||Most credit cards have a £5,000 introductory limit|
|No mileage limit||If 0% interest rates aren't available, credit cards typically have higher APRs than other car finance options|
|0% interest rates are available||Have to transfer balance to keep on top of interest rates|
|Flexible monthly payments||You bear the brunt of the car's depreciation|
|Extra payment protection|
How To Get The Best Car Finance Deal
Selling car finance deals is important for dealerships. It's no secret that there's often more money in a finance agreement and additional finance products (e.g. GAP insurance and extended warranties) than the car itself, especially when it comes to new cars.
The most important thing to understand when it comes to car finance is the APR (annual percentage rate) which is the rate of interest you're paying over the duration of your agreement.
If you can afford to pay a higher monthly fee over a shorter term you'll end up paying less for the same car, especially when you opt for a HP agreement or take out a personal loan.
Once you know which finance method is best for your circumstances, you should shop around to find the best deal. If you want to finance directly through the dealership, they might even be able to match the offer you've found.
July 08, 2019 at 4:07 PM