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Buying a car on finance is a great way to get the one you want for the right price but some of the jargon involved can be confusing. Our simple guide explains all.
Many of us buy a car on finance because it’s a good way to spread the cost over a number of years. That can make the car more affordable and you know exactly how much to budget for it each month. Understanding car finance can be a challenge, however, with lots of specific language and terminology to get your head around.
To help you get to grips with it all, we’ve put together this A-Z guide to car finance jargon.
The agreement is a legally binding contract between the borrower (you) and the lender (the finance company). It outlines the schedule of payments, interest, fees and charges, and spells out your rights and responsibilities. Read it carefully and make sure the costs of the car are the same as you’ve been quoted. Ask questions or get a second opinion if you’re unsure about anything in the agreement.
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Not to be confused with the total amount payable, the amount of credit is the amount of money being lent to you by the finance company. This figure will exclude the deposit or the amount you’ll be given in part exchange for your current car.
When you apply for personal contract purchase (PCP) finance, you’ll need to estimate your annual mileage. (See the PCP section below.) This is the maximum number of miles you can drive each year without incurring any additional fees. It’s important to get it right, because you’ll be charged per mile over the agreed maximum mileage. Costs vary, but lenders tend to charge between 10p and 20p for every mile over the allowance.
APR is the annual cost of borrowing. It includes the interest you’ll pay on finance, as well as any fees associated with the borrowing. The APR figure must be shown on all quotations and advertising materials, so it’s a good way of comparing different finance deals.
There are two types of APR: actual and representative. They’re calculated in the same way, but representative APR means that 51 percent of the applicants will get the rate advertised. The remaining 49 percent of applicants will be offered a different, usually higher, rate. Actual APR is the interest rate you’ll get when borrowing. (See the interest rate section below.)
When you enter into a finance agreement, the lender will predict what the car’s value will be at the end of the contract. That value is given as the ‘balloon’ or ‘optional final’ payment. If you decide to pay it, the car is yours. If not, you can return the car to the dealer and get your deposit back. Or you can trade it in for another car the dealer has, using your original deposit. Any charges for wear and tear or excess mileage will be added to the final balloon payment.
The credit rating (also known as credit score) is an assessment of your suitability for credit. When you apply for car finance, the lender will check your credit rating to help make a decision on your application. A soft check is a preliminary check to understand if you’re eligible for a loan from certain lenders, while a hard check is completed once you’ve applied for credit and the lender reviews your credit report.
A higher credit score means lenders see you as a lower risk, so it’s a good idea for you to check your rating before applying for a loan. Settling bills on time and repaying any money you owe will help improve your credit score.
The deposit, also known as a customer deposit, is the payment you make at the start of the finance agreement. A larger deposit tends to result in lower monthly payments, but consider all your options before signing an agreement. Note: it’s unlikely your deposit will be refunded if you cancel your finance contract, so paying a large amount upfront isn’t always the best option.
Car dealers and manufacturers sometimes offer a deposit contribution, which goes towards the cost of the car. In some cases, you have to add your own deposit as well. Deposit contributions are usually offered with a particular finance deal and won’t be available if you don’t take that deal.
Deposit contributions can be quite large, reducing the monthly payments significantly. But make sure you go over the details of the deal. The headline figures may look great, but the terms of the deal may not suit you.
This is the value your car loses over time. Car depreciation is particularly steep in the first year, but the rate slows after the third year. That’s why buying a nearly new car can make sound financial sense - the original owner will have swallowed a large chunk of the depreciation.
In the case of a PCP deal, you’re essentially paying for the depreciation over the length of the contract, so buying a car with a low depreciation rate will cost you less per month.
An early settlement, also known as redemption or early repayment, is the amount payable should you decide to pay off the loan early. The lender will provide a settlement figure, which is likely to include an early repayment charge. That said, you will save money, as there may be less interest to pay.
This is the difference between the market value of the car and the amount you owe to the finance company. For instance, if the car is worth £15,000, but you still owe the finance company £20,000, you have negative equity of £5,000. If the car is worth £15,000 but you only paid £10,000, you have positive equity. Although that’s unlikely to happen.
Negative equity could be a problem if you want to pay off the loan early, because you could end up paying more than the car is actually worth.
This is the amount you’ll have to pay for every mile you drive over the agreed annual mileage. Excess mileage is commonly associated with PCP and lease deals On those deals, your monthly payments are based on the car’s value at the end of the contract. Extra miles reduce the car’s value, so you have to pay the difference. (See the annual mileage section above.)
The FCA regulates the financial services industry in the UK. The regulator's role is to protect consumers when arranging financial deals. All car finance agreements fall under the jurisdiction of this independent regulator.
GMFV is what the car will be worth at the end of the finance agreement. The lender will estimate the GMFV based on the length of the contract, the total mileage covered and market trends. The optional final payment, or balloon payment, should match the GMFV. (See the balloon payment section above.)
The GMFV is based on the assumption that you stay within the mileage allowance, maintain the car to the recommended standards, and keep the car in good condition.
HP is perhaps the most traditional form of car finance. Your monthly instalments pay off the total cost of the car, so once you’ve paid the final instalment you own the car. The interest rate is fixed for the full term, the amount borrowed divided into equal monthly payments, usually up to 60 months (five years).
Paying a higher deposit will lower the cost of your monthly repayments. But you won’t actually own the car until you make the final payment. HP is ideal if you intend to keep the car at the end of the contract.
Interest is the charge you pay for borrowing the money to buy a car on finance. The interest rate is spread out over the monthly loan payments. Your finance agreement will tell you the total cost of the interest that you’ll pay during the loan. The rate is fixed, so the shorter the finance contract is, the less you’ll spend on interest.
A part exchange is using the value of your current car as a contribution to the cost of a new one.
It can reduce your monthly payments, as the value of your car is deducted from the cost of the car you want to buy. The value of your part exchange depends on a number of factors that will be considered by the dealer, including the car’s age, condition, service history and current market value.
PCH, also known simply as contract hire, is a long-term lease or rental agreement. At the end of the term you simply hand the car back to the leasing company. Assuming you’ve maintained the car and kept within the mileage allowance, there’s nothing more to pay. The monthly payments tend to be lower, but make sure the price you’ve been quoted includes VAT. You’re unlikely to be given the option to buy the car when the lease ends.
PCP deals can be attractive as the monthly instalments are lower than for most other forms of leasing and finance. That’s because a large chunk of the car’s value is put at the end of the contract in the form of a balloon payment. Pay that and the car is yours to keep.
Alternatively, you can return the car to the lender to get your deposit back. Or get another deal from the same lender, using your current car as part of the deposit.
Find out more about Personal Contract Purchase (PCP) finance here
This is the market value at any point during a car’s life. The lender will predict the car’s residual value at the end of the finance agreement to calculate your monthly payments. A car with a low rate of depreciation will have a high residual value, so tends to be more affordable to finance than a car with a high rate of depreciation.
Market trends, a car’s popularity and its brand image are just three of the factors that influence residual value.
This is the total amount needed to pay off your loan in full. Your lender can confirm the settlement amount at any point during the contract. If you have paid off half the total amount payable and are up to date with your monthly payments you also have the right to simply hand the car back. This is known as voluntary termination.
This is the length of your finance agreement and can vary between 24 and 60 months (two to five years).
Also known as total repayable, this is the total cost of the car including the loan itself, the total amount of interest payable and any fees. It’s likely to be significantly higher than the price you’d pay if you bought a car outright in cash.
You have the right to end your finance agreement and return the car if you have repaid 50 percent of the total amount payable and you have taken reasonable care of the vehicle. In the case of a PCP deal, the amount includes the final balloon payment, so the halfway point is much later in the agreement. In HP contracts, the 50 percent point is about halfway through the agreement.
A finance company will lend you money under the assumption that you’ll maintain the car and keep it free from damage. That said, a degree of wear and tear is expected, so you’re unlikely to be penalised for stone chips on the bonnet, a few scratches on the bodywork and some dirt on the alloy wheels.
Anything beyond this, such as kerbed alloy wheels, dents on the body and missed service intervals, is likely to be considered beyond fair wear and tear. You will be charged a fee in addition to your final payment. This applies to PCP and PCH deals, but not to a car bought on HP.
When taking out a car finance arrangement, the finance company should provide you with fair wear and tear guidelines – always check the information provided carefully so you know what's acceptable.
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