The price of both new and secondhand cars has rocketed in recent months, with most buyers reliant on finance to fund their purchases.
More than 2.2m new and used cars were bought with finance by UK consumers in the twelve months to April 2022, according to the Finance & Leasing Association (FLA).
If you’re borrowing to fund a new or secondhand car purchase, the different options can be daunting so here, we outline the main car financing options and their pros and cons, to help you decide on the right type of car finance for you.
What is car finance?
Car financing is a specially designed type of loan that helps to spread the cost of buying a car over several years. The average cost of new and used cars ranges from £13k to £38K, depending on which model you choose, according to Statista and AutoTrader, a cost few people can afford outright.
There are different types of car finance, and which will suit you depends on your personal situation and how much you’re looking to borrow. Perhaps you want to buy the car outright and drive it for years, in which case hire purchase might be right for you. However, if you like to change your car on a regular basis, then you might want to consider personal contract purchase, for example.
How does car finance work?
There are different types of car finance products which we explore below, but generally, when looking to take out car finance you’ll follow the below steps:
- Do your resarch and choose the car you want.
- Decide if you want to buy the car with car finance offered by the dealer or via a third party, such as a bank, building society, or a car finance company. Beware that dealers may push you to use their car finance products and might even offer discounts, but you can usually use other companies or organisations, so it’s important to shop around for the best deal.
- Decide on the type of car finance you would like to take out.
- Agree with either the car dealer or lender on the terms and conditions of the finance deal, and how long you want the loan term to last.
- Check that you’re comfortable with the length of the loan term, the amount of deposit you’re putting down and the interest rate you’ll be charged. If you choose a personal contract purchase car finance deal, the terms and conditions will also include a mileage allowance/agreement or cap and a guaranteed minimum future value. We cover these in more detail below.
- You pay your deposit and are given the keys to your car.
You’ll then pay your agreed monthly payments for the duration of the loan term, and what happens when it ends will depend on the type of car finance you’ve chosen.
There are a few different types of car finance:
Hire purchase is one of the most popular types of car finance and it could work well if you want to eventually own a car outright.
Hire purchase works by securing your loan against the car you want to buy. This means that your lender technically owns your car and you’re hiring it from them. You’ll pay your lender a set number of monthly payments over the loan term and you’ll eventually become the owner once you’ve made your final payment. However, if you miss any payments, your lender could potentially seize the car from you.
If you decide that you want to buy the car outright at any point during the loan term, you’re usually able to, but you might pay a penalty fee. Alternatively, if you decide that you don’t want the car anymore, some lenders have a feature that enables you to return the car back once you’ve made half of your payments.
With most hire purchase agreements, you’ll need to put down a deposit when you take out the loan, which usually amounts to around 10% of the car’s value. Some lenders might let you pay less of a deposit, but remember the less you put down initially, the higher your monthly repayments are likely to be and vice versa, so if you’re able to it’s usually better to pay more upfront.
How does hire purchase work?
Hire purchase is one of the more straightforward car finance products, as the amount you’ll need to pay is based on three factors: the cost of the car, your deposit, and the interest rate.
For example, let’s say that you want to buy a car that costs £25,000 through a hire purchase agreement that runs for five years (60 months) at 6.9% APR and you have a deposit of £1,000. You would end up paying a total of just over £29,300 made up of 60 monthly payments of around £470 and your deposit (based on figures from carmoney.co.uk).
Benefits of hire purchase
- Requires a low deposit, but for the lowest monthly payments, it’s a good idea to put down a larger deposit. Some lenders will even offer you 0% interest if your deposit is big enough.
- You don’t have to worry about mileage limits.
- Interest rates are usually fixed.
- Payment amounts are usually fixed, and you can choose from a range of term lengths – anywhere from 12 to 60 months.
- You’ll own your car once all payments have been made.
Downsides of hire purchase
- Your monthly payments could be higher than other financing options.
- If you miss payments your car could be repossessed.
- You don’t own the car, so you can’t sell it part way through the loan term if the payments become too much.
- As cars typically depreciate in value, you will take the hit, not your lender.
- If you miss payments, it could affect your credit score.
Personal contract purchase
Personal contract purchase (PCP) is another really popular way of financing a car and may attract motorists who want to change their car every few years.
PCP is similar to hire purchase, as you’ll still pay a deposit (usually 10%) and monthly payments to your lender, but the way your loan value is worked out and your options at the end of the term are different.
The value of your PCP loan is based on the difference between your car’s value today and its value at the end of the loan term. This makes PCP more complicated than other options, but essentially, your lender uses factors like your predicted annual mileage and the general depreciation rate of your car to work out what it thinks your car will be worth at the end of your agreement. This is known as its guaranteed minimum future value (GMFV), and is the amount your lender guarantees to pay you at the end of your loan if you want to hand in your car or trade it in on a new PCP deal.
For example, if you were looking at a car worth £33,000 and planned on driving 12,000 miles a year for three years, by the end of the loan term it might be worth £25,000, making the value of your loan £8,000. You’ll be charged interest on this amount and pay off your loan in monthly instalments.
When you reach the end of your loan term, you will have only paid off a portion of your car’s value and you have three options:
- You can hand back the car to your lender, in which case there’s no extra money to pay.
- You can put the value of your car towards buying a new car on another PCP deal. If your car is worth more than the GMFV, you’re normally given a discount on the value of the car you want to buy.
- You can make a final payment called a ‘balloon payment’ so that you can keep the car. It’s normally several thousand pounds but can be much more, depending on the original price of the car and the guaranteed minimum future value agreed at the outset.
How does personal contract purchase work?
If you’re looking into getting a PCP finance deal it’s best to break it down into three core elements:
Your deposit – this is the amount that you’ll pay upfront. You choose how much you pay but usually, this will be between 10% and 30% of the value of the car. As ever, the more you pay as a deposit, the lower your monthly payments are likely to be.
Your monthly payments – this will be the value of your loan broken down over the course of your loan term, which is usually anywhere from 18 to 48 months. You’ll also pay interest on this.
Final balloon payment – When you reach the end of your PCP agreement, you can choose what to do next, including handing the car back, using it as a downpayment on another car or buying it outright. If you choose to buy it outright, you’ll need to make a final payment, which is the GMFV. This will be a significant amount of money, and if your plan is to keep the car anyway, then hire purchase could be a more affordable option.
Benefits of personal contract purchase
- You don’t normally have to put down a large deposit.
- The monthly payments are relatively low compared to what you’d pay if you had a personal loan. This means you can drive a newer or better car (or both) than you’d otherwise be able to.
- You have flexibility about what you do at the end of the agreement.
- Maintenance and servicing can be included in the finance deal.
- Your car’s minimum worth is guaranteed so you’ll know what you can get if you want to trade it in on a new PCP deal.
Downsides of personal contract purchase
- You won’t own the car until you make the final payment. If you can’t afford this, you can’t keep the car.
- You may have to pay extra charges if you go over the mileage allowance. These are usually a certain amount per mile.
- You must have fully comprehensive car insurance.
- You normally have to have the car serviced every year at one of the manufacturer’s approved dealers. You can’t use a cheaper independent garage. However, this may be included.
- If you trade up every time your PCP deal comes to an end, you’re constantly in debt.
- If the car is damaged or in poor condition at the end of the term, there may be a deduction.
- If you keep the car, you may end up paying more for it than if you chose hire purchase.
- Your lender may place limits on taking your car abroad, so if you’re planning an overseas road trip , you may need to check your terms and conditions to see if there are limits on the length of time you can be away.
Personal contract hire/leasing
Unlike the previous options, with personal contract hire (PCH), you’ll never actually own the car, as you’re effectively renting it from your lender.
PCH is a good option for people who want to have a brand new car for a relatively low cost but don’t want to worry about maintenance and don’t want to ultimately own the car.
With PCH, you’ll pay your lender a fixed monthly payment, which will cover the cost of the car, plus servicing and maintenance, making it a pretty comprehensive option.
Of course, the flip side of this is that your money is going straight into your lender’s pocket, rather than towards eventually owning a car outright. So, while you will have a car to use during the term of the deal, when your agreement ends, you’ll have to hand the car back.
Benefits of personal contract hire
- You can get a brand new car for low monthly payments.
- Your payments are fixed.
- Your maintenance and services are included in the cost..
- You might be able to afford a more expensive make and model than if you were buying.
- You can get a brand new car every 2-4 years.
- You never have to worry about re-selling your car or depreciation.
Downsides of personal contract hire
- While service and maintenance costs are included, they also make your monthly payments more expensive
- You’ll usually need to put down three months’ rental as a deposit
- Your mileage is limited to a pre-agreed figure and if you exceed this, you’ll have to pay an excess charge.
- You’ll have to pay for any damage beyond normal wear and tear.
- You can’t make any modifications to the car, you’ll get it just as it is.
- You’ll never own the car.
Rather than choosing any of the above options, you might consider taking out an unsecured personal loan from a bank or building society to fund a car purchase. A number of banks will offer loans, giving you the option to buy a car anywhere between £7,500 and £25,000 over one to seven years.
Personal loans are likely to be the most cost-effective way of buying a car if you have a good credit score, as the interest you’re charged is likely to be lower. You also have more flexibility on what you can do with the money, as you can use it to buy a car or put towards any other purchase.
Benefits of a personal loan
- This is usually the cheapest way to buy a car if you need to borrow to fund the purchase, provided you have a squeaky clean credit score.
- Rates are competitive, from just 2.8%.
- You choose exactly how much you want to borrow.
- You have freedom to choose the car you want, whether that’s a new or used car from a dealer or private seller.
- You might be able to negotiate a better deal if you know how much you can spend.
- You own the car outright from the start so you can sell it if you want.
Downsides of a personal loan
- The best deals are only available for people with a high credit score.
- Taking a personal loan could affect how much you can borrow elsewhere.
- If you sell the car, you’ll still need to make regular repayments until the loan is repaid.
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Whatever option you choose, there are a few important things to remember:
A growing number of finance firms are offering car finance deals as more people are taking these out to fund a car purchase, so it’s likely whatever car you choose there will be a variety of deals available. It’s really important to do your homework, and find the right option for you at the best rate.
Read the fine print
Ensure that you fully understand what you are signing up for when entering into a car finance agreement. Repayments on car finance may be one of your biggest monthly outgoings after housing costs, and in most cases, you’ll be agreeing to make repayments for at least 18 months, so it’s an important commitment.
Make sure that you understand any limits that apply to you and your car finance deal, such as mileage, or you risk facing unexpected costs later on.
Take your time
Take your time deciding on the right car finance deal. Don’t feel pressured into making a decision that’s not right for you. Remember, until you’ve signed on the dotted line and handed over your deposit, you aren’t under any obligations to go ahead with the purchase.