What is car finance?

What is car finance and how does it work?

Navigating the world of car finance can be confusing. Our guide explains the basics of car finance and how it works.

By Harriet Meyer

Published: 18 September 2023

Many people choose some form of finance when buying their car, but how does car finance work and what are the main options available to you? Our guide breaks down the jargon and answers your key questions.

What is car finance? 

Car finance is a term that covers the different types of loans available if you need to borrow money to buy a car or to rent one for a set period. It makes owning a car more affordable by spreading the cost of your car across several years. 

The best car finance deal for you will depend on three factors: whether you want to ultimately own the car; your personal and financial circumstances; and how much you want to borrow.

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How does car finance work? 

Whatever type of car finance you choose, you’ll borrow money from a lender to eventually own a new or used car, or to drive it for a specific period of time. You’ll usually pay an initial deposit, and then fixed monthly repayments for the duration of your agreement. 

As part of your car finance contract, you’ll need to stick to certain rules. These may involve, for example, servicing the car according to its manufacturer's schedule, or not going above  a set number of miles each year. Once you’ve paid what you owe, depending on the terms of your contract you’ll either own the car outright, pay a final lump sum to buy it, or return the car.  

If your circumstances change you have options if you want to end a car finance agreement early, or if you want to carry any equity over to a new agreement as part of purchasing a different car.

How do you apply for car finance? 

To apply for car finance, you’ll need to provide the lender with some personal details and supporting documents, including your employment details. The requirements vary according to the type of finance and the lender, but you must be over 18.

The lender you're applying to will carry out a hard credit check, to assess your credit history and current financial position. The higher your credit score is, the more chance you have of your application being accepted. 

A hard credit check will show up on your credit score. If you make several applications in a short space of time this can have a negative effect on your credit score. If you’re accepted for a car finance agreement, however, making regular repayments could in turn boost your credit score.

Why do people get car finance? 

Why buy a car on finance? Your reasons can vary, including: 

  • It helps you to plan your monthly budget over a long period

  • You can afford a newer, better car by spreading the cost over time

  • You can extend or upgrade an existing car finance package

  • It’s just the way you’ve always done it!

What are the different types of car finance?

The two most popular types of car finance are personal contract purchase (PCP) and hire purchase (HP). 

Here’s how each one works: 

Hire purchase (HP)

If you choose HP finance, you’ll pay an initial deposit, then make regular payments to cover the cost of the car and the interest on your loan over the term of your deal. Once you’ve made your final payment, which will usually include a small option-to-purchase (OTP) fee, you’ll own the car outright. You can usually choose a repayment period you’re comfortable with (typically between 24 and 60 months).

Personal contract purchase (PCP)

With a PCP agreement, you’ll pay a deposit and take out a loan to cover the amount that the car will fall in value over the contract period (usually between 24 and 48 months). You’ll make monthly repayments with interest over the length of the contract and you’ll only own the car outright at the end if you pay a lump sum known as a ‘balloon payment’ (and any OTP fee). 

You may decide to return the car, or sign up for a new car and another loan instead. This car finance option may suit you  if you like to frequently change your car and want monthly repayments that are lower than with an HP deal. 

You can read more about the differences between PCP and HP in our detailed guide here

Are there any other types of car finance?

Other types of car finance are available, including a personal loan, a conditional sale (CS) or buying a car with a credit card. Here’s an overview:

Personal loan

You could take out an unsecured personal loan from a bank or a building society to cover the cost of a car. You’ll own the car outright immediately, and pay back the loan, with interest, to your particular lender over a set term. The amount of interest you’ll pay will depend on how much you borrow, your chosen term (usually one to five years) and current interest rates. 

Whether a lender will give you  a competitive rate will depend on factors including your credit history. 

Conditional sale (CS)

Condition sale is similar to Hire Purchase (HP), the only difference being that you don’t pay an option-to-purchase (OTP) fee. You pay a deposit, then fixed monthly payments and at the end of the contract you become the owner of the car. 

Credit card

It’s possible to use a credit card to pay – in part or in full – for a new or used car. Some dealers won’t accept this payment option, however, and although you may be able to find a credit car with an introductory 0% interest offer this will generally only be for a short period (usually 12 months), after which the interest rate could be much higher than for other types of car finance. 

Is leasing a type of car finance?

Leasing, also known as Personal Contract Hire (PCH), isn’t a type of car finance as such. Instead, it’s simply a way of renting a new or used car for a set period. As with PCP or HP, if you’re leasing a car you pay a deposit and make fixed monthly payments, but you won’t have the option to own the car at the end of your contract. 

Leasing deals usually run for two to four years, and include a mileage limit. You can pay more for a higher mileage allowance and there are fees to pay if you exceed that limit, or if the car has damage beyond ‘reasonable wear and tear’ when you hand it back at the end of the contract.

Does car finance mean you own the car?

If you take out a PCP agreement you’ll only own the car outright if you make the final lump sum (balloon) payment and any OTP fee at the end. With HP you’ll own the car once you’ve made your final repayment (which will include an OTP fee). With  CS you’ll own the car once you’ve made your final monthly payment. 

If you buy a car using a personal loan or credit card, you will own the car from the outset.

Can I get car finance with bad credit?  

You may struggle to get car finance if you’ve got a bad credit history, but there could be options. You may find the choice of deals limited, and interest rates could be higher than those on standard deals. You also could work on improving your credit score before you buy to give you more options.

Here’s our guide to getting car finance if you have bad credit.

What happens if you crash a car on finance? 

If you crash a car that’s under a finance agreement, you’re responsible for the cost of repairs. You could make a claim on your insurance for the damage, and pay your policy’s excess. You’ll still need to keep up with your monthly car finance payments. If your car is written off, you’ll be offered a settlement figure by your insurer. If this amount doesn’t cover your outstanding debt, you’ll still need to pay the remaining amount owed to your lender.

Which car financing option is best for me?

The best car financing option for you depends on a number of factors including whether you want to own the car at the end of the contract, how much you can afford to pay upfront, your credit rating and the cost of the car you want to buy.

You should consider what finance options are available for the model you want, and what rates are available to you based on your credit score and personal circumstances. 

Also, consider how far you drive to ensure that a particular deal will work for you based on the terms and conditions – you may find there are penalties if you drive more than a certain number of miles per year, for example. 

Compare deals across the market before you sign up. Check set-up costs, early repayment charges and the terms of any agreement carefully.

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