How Does Financing A Car Work?
Most car finance agreements require you to pay a deposit for a vehicle, followed by fixed monthly payments over the course of a few years. Depending on which type of finance you choose, you can buy or return the car when your contract ends.
Which car finance is right for you will depend on your budget and whether you want to own the car – or upgrade your model every few years.
Discover which type of car finance is right for you by reading our handy guide explaining how each method works.
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How does Personal Contract Purchase (PCP) work?
- Where to get PCP deals: manufacturer dealerships, finance providers and car supermarkets
- Types of cars available: new and used cars
PCP works like a traditional bank loan, but you won’t borrow the full amount of the car you’re interested in.
At the start of a PCP agreement you’ll be required to put down a deposit of around 10% of the car’s value. After you’ve paid the deposit, you’ll then make fixed monthly payments towards your loan amount for the length of your term (usually this is 24-60 months).
Your monthly payments are calculated using the interest rate (APR) and how much the car is expected to depreciate over your term (known as the ‘guaranteed minimum future value’, or GMFV). Once you take away your deposit, the monthly payments cover the difference between the price of the car at the beginning and the GMFV.
At the end of a PCP deal you’ll be given three options:
- Own the car for a lump sum, known as the ‘balloon payment’
- Hand the car back and walk away (the vehicle must be in good condition and within the total annual mileage agreed at the start)
- Use any positive equity towards the deposit on your next car.
Let’s imagine you’re looking to finance a new car on a PCP agreement* across 36 months.
- The car you want is valued at £25,000
- You pay a 10% deposit of £2,500
- The finance provider predicts the GMFV of the car will be £16,686 after the 36 months is up
- So, you’ll need to borrow and pay back £10,000 plus interest (£25,000 – £2,500 deposit – £16,686 GMFV)
- At 5% APR over 36 months, your monthly payments will be £243.78
*All calculations were made using TheMoneyCalculator’s PCP calculator. Prices shown are indicative, and your monthly payments may differ depending on interest rates, your credit score and the GMFV of your car.
Can you cancel a PCP agreement early?
As long as you’ve paid 50% of the total finance on your PCP agreement, you’ll be able to hand your car back early. This is known as voluntary termination and, under UK law, is the right of everyone taking out a PCP deal on a car.
For the reason above, you can’t simply cancel your PCP deal at the halfway point, as it’s unlikely that you will have paid 50% of the finance. You should also note that if you’ve already paid more than 50% of the finance, you won’t be refunded for the difference – i.e. if you’ve paid 55% of your PCP finance, the finance provider won’t give you a refund for the extra 5%.
When it comes to handing the car back, you’ll need to make sure that it’s in good condition. Some wear and tear is expected, as long as there’s no obvious damage.
Advantages and disadvantages of PCP
- PCP deals are one of the most flexible forms of finance when it comes to options at the end
- Because PCP agreements are calculated based on depreciation, you’ll have positive equity to put towards another car if values hold or rise
- You may be able to benefit from manufacturer incentives, such as deposit contributions or low interest rates
- PCP deals could suit people who want to change their cars every few years
- Used and new cars available
- You’ll need to pay a large balloon payment in order to own the car at the end
- If you hand the car back with damage or mileage that goes above your agreed limit, you’ll face extra charges
- PCP deals can be expensive if you have poor credit history due to higher interest rates
- Cancelling your agreement early can seem unaffordable
- If your car is worth less than the GMFV at the end, you won’t be able to put money towards your next car
Changing your car on PCP
The flexibility of PCP finance agreeements is what makes them popular with many UK drivers. This is true when it comes to wanting to change your car too. Like we mentioned earlier, you can end your agreement early if you’ve paid 50% of the total finance and go on to get another car.
Alternatively, the most common way to change your car on PCP is to swap it for another one at the end. Because most finance providers underestimate what the car will be worth at the end of your deal, you will tend to have equity in the car that you can put towards the deposit on your next model.
Here are are a few things to be aware of before changing your car on a PCP agreement:
- You can trade your car into another dealer if they’re valuing the car higher than your original dealer they will take care of the settlement of your current finance agreement.
- Check with your finance provider whether you have any equity in your current car (i.e. it’s worth more than the balloon payment) so you can decide whether to trade it in or give it back and walk away.
- If the car is worth less than the balloon payment, you have the option to either refinance this amount and continue paying off the car until you’re no longer in negative equity.
- Should you decide to hand your car back, make sure the car is in a condition that is within the fair wear and tear guidelines and that you’ve stuck to your agreed annual mileage beforehand. Otherwise you will be charged extra by the car finance provider.
Want to find out more information regarding PCP finance before making a decision? Check out our other guide which talks about the advantages and disadvantages of PCP.
How does Hire Purchase (HP) work?
- Where to get HP deals: manufacturer dealerships (online and offline), finance brokers and car supermarkets
- Types of cars available: new and used cars
HP agreements work in a similar way to PCP deals, but the loan amount differs. Instead of borrowing the difference between the car’s price at the start of the agreement and its GMFV, you borrow and repay the whole value of the car. You then repay this Before you get in your new car you’ll need to pay a deposit of 10% or more of the car’s value. The rest of your finance is split into fixed monthly payments over the course of 24-60 months.
The main difference between HP and PCP finance is the final payment to own the car at the end, should you choose to. For HP deals, this is a small fee known as the ‘option to purchase’ (usually around £100). For this reason, the monthly payments for the vehicle tend to be higher than those on a PCP agreement.At the end of your contract you don’t have to pay the fee, and you can simply choose to hand the car back. However, you’ll need to make sure there’s no damage that goes beyond what constitutes fair wear and tear.
Looking for more information to help you decide on the right type of car finance? Check out our other guide for differences between PCP and HP to help you decide.
Suppose you’ve seen a new car that you want to buy, so you decide to finance it on a HP deal* for 60 months.
- The car is valued at £25,000
- You pay a 10% deposit of £2,500
- You’ll borrow and repay £25,000 over 60 months
- At 5.5% APR, the finance provider calculates your monthly payments to be £429.78
- You’ll have the option to purchase the car for a fee of around £100, or you can hand the car back
Can you cancel a HP agreement early?
Just like a PCP agreement, you can cancel your HP agreement early using your right to a voluntary termination. This does mean you’ll need to have paid 50% of the total finance beforehand.
It’s more likely that 50% of your finance will have been paid halfway through a HP deal because the monthly payments are higher. There’s also no balloon payment like there is with a PCP deal due to the loan being secured against the car.HP finance is a type of secured loan, so the finance company can repossess the vehicle without a court order until a third of the loan has been repaid.
Advantages and disadvantages of HP
- There’s no mileage limit for HP agreements
- Flexible terms ranging from 12-60 months
- You can return the car early if you’ve paid 50% of the finance
- Low option to purchase fee at the end means you can own the car for not much money
- Because HP agreements are a type of secured loan, you may find it easier to get a car on this type of finance if you have bad credit
- Monthly payments are usually higher than PCP and leasing
- You won’t own the car until you’ve made the final option to purchase payment
- HP agreements can be expensive if you want a shorter term
- The finance company can repossess the car without a court order up until you’ve paid a third of the car loan
- You can’t make modifications to the car without permission from the finance company
Changing your car on HP
HP agreements are structured so that once you’ve made your final monthly payment, you’ll only need to pay the circa £100 option-to-purchase fee before owning the car. However, it might be that you don’t want to own the car, in which case you can refuse to pay the fee and the car will go back to the finance provider.
In this instance, changing your car would be very easy – you’d just need to go and buy a new one through a method of your choosing.
However, if you pay the option-to-purchase fee and own the car, you can choose at any point to sell the car to fund a new one because it’s yours to do with as you please.
How does personal leasing work?
- Where to get personal leasing deals: car leasing comparison website, manufacturer dealerships (online and offline), finance providers, third-party providers
- Types of cars available: new cars
Personal car leasing (also known as Personal Contract Hire, or PCH) is essentially long-term rental of a brand-new vehicle that usually lasts from 24-48 months. At the end of your agreement you won’t have the option to own the car – you simply hand it back to the finance company.
The way car lease finance works is that it’s calculated based on how much it depreciates over the course of your agreement.
A finance provider will take into consideration three things before quoting you a monthly price for a lease car:
- Initial payment: this acts as a first installment for the car and you can usually choose to put one, three, six or nine months’ worth of the advertised rental down as an initial payment.
- Contract length: often displayed in months, you can usually lease a car anywhere from 24-48 months.
- Annual mileage: before you lease a car you’ll need to decide how many miles you want to drive it each year. This can range from 5,000-30,000 miles.
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Personal leasing example
- You’ve seen a car you like which costs £200pcm to lease for 36 months
- You decide to pay an initial payment worth three months of the car’s monthly payments, so £600
- Your remaining monthly payments are 35x £200pcm because your initial payment covers the first month
- In total you’ll pay the finance provider £7,600 to hire the car over your term
- At the end you hand the car back with nothing more to pay – provided you’ve kept the vehicle in good condition and haven’t exceeded the annual mileage
Can you cancel a personal lease deal early?
Once you’ve ordered your lease car, you have a 14-day ‘cooling-off’ period whereby you can cancel your agreement and not have to pay a penalty. You’ll also get your money back if you’ve paid an initial payment and/or processing fee to the provider for putting the deal through
This is UK law under the Consumer Contracts Regulations and applies to any goods or services sold at a distance/off-premises.
After the 14 days have passed, you’ll have to pay a fee to cancel your agreement early, plus the remaining finance outstanding on the car. For this reason cancelling a lease agreement can often be a very expensive option that you should try and avoid.
If you can no longer afford the monthly payments for a car you’ve leased, check out our guide on how you can get out of a car lease.
Advantages and disadvantages of personal leasing
- Car leasing is ideal if you want to drive the latest model every few years
- You won’t own the car at the end, so you never need to worry about depreciation leaving you out of pocket
- Finance is based on how you use the car – you decide the terms and pay what you’re comfortable with
- All the cars are brand-new and include the manufacturer’s warranty, so you won’t have to fork out for unexpected issues
- Road tax is often included within the monthly payments for at least the first year
- Annual mileage restrictions mean you’re limited to how you use the car
- You won’t be able to make modifications to the car without first getting permission from the finance provider
- End-of-lease charges will apply if the car isn’t in good condition or you’ve exceeded your total annual mileage
- Poor credit history can make it difficult to lease; if you do, a higher upfront payment and/or monthly payments may mean it’s unaffordable
- You may need extra cover like GAP insurance to avoid an expensive payout if the car is written off or stolen
Changing your lease car
The most common way to change your lease car is to wait until the end of your agreement and speak to your provider about upgrading to a newer model.
But some leasing providers will be able to look potentially letting you change your car early if your circumstances mean you need a new car. This is done on a case-by-case basis and you’ll be sent a new leasing quote that could be higher because payment for the new car plus outstanding finance on your old model would be factored in.
Here are a few things to be aware of before changing your lease car:
- Make sure you can afford the monthly payments for the car over the term that you’ve specified. If you need help choosing, check out our guide on the most popular car terms.
- Before changing your lease car early, remember to confirm all extra fees and additional costs with your provider so that the payments don’t become too much.
- If you’re waiting until the end of your lease agreement to upgrade, read up on everything you need to know about returning the car so that you avoid potential extra charges.
How does a personal car loan work?
- Where to get a personal car loan: bank or building society
- Types of cars available: you can take out a loan for new and used cars
A personal loan is one of the more traditional methods of financing a car – either all or part of it. You can go through your existing bank to get a loan for a car, or whichever bank/building society is offering the best APR interest rates and monthly repayments.
With a personal loan you can usually borrow up to £25,000 and repay the amount over 1-7 years. Before you commit to a personal car loan, make sure that the interest rates are fixed and not variable. If they’re the latter, you run the risk of rising interest rates making loan repayments unaffordable.
You should also check the monthly repayment amount and total cost of borrowing. This will tell you which option is the cheapest.
To find out where you can get the cheapest car loan, we recommend using a free loans eligibility calculator. This ‘soft search’ won’t negatively affect your credit score and will match you with a lender that best suits your situation.
Do you want to find out whether a bank loan or car finance is best for you? Read our guide comparing PCP and bank loans to help you decide.
Personal car loan example
Let’s say that you want to borrow £10,000 to purchase your next car using a personal loan and repay this over seven years. Here’s how that might look.
- At 5.8% representative APR interest rate your monthly payments will be £145
- The total amount repayable is £12,180 (84 repayments of £145 including interest)
- Because the interest rate is representative, only 51% of accepted applicants need to get this rate. As such, you should be prepared to pay slightly more in the case that interest rates rise over the seven years
Can you cancel a personal car loan agreement early?
Personal car loans come with a cooling-off period of 14 days where you can decide if the loan is right for you. This period is 14 days from the date when you sign the agreement or you receive a copy of it – whichever is later.
If you decide to withdraw from your loan agreement in the cooling-off period, you’ll still need to pay any interest and/or capital that has built up over this time.
Cancelling your loan after this point doesn’t end the agreement to buy the car from the dealership or provider. So in this case you’d still need to find a way to pay for it.
Your other option is to agree a settlement figure with the lender to cover the full loan amount. Or you could look at getting a partial loan settlement to make the loan smaller. In either case you should get a rebate of any future interest/charges you’ve paid, but this will be less in the case of a partial settlement.
Advantages and disadvantages of a personal car loan
- One of the most simple ways of financing a car
- A payment schedule is usually set up with your bank for a personal car loan, so you can easily find out exactly what you’re paying each month
- Flexible terms let you repay a loan over 1-7 years, but remember that a longer contract means you’re likely to pay more in interest
- You can arrange everything over the phone, online or face-to-face
- You’ll own the car while paying off the loan so you can choose to sell it if you’re struggling to pay the finance
- Advertised APR interest rates are often ‘representative’ or ‘typical’, meaning only 51% of people approved for a loan will get this rate
- You may end up having to borrow more than you originally planned as certain brackets for loan amounts (i.e. between £3,000-£5,000) can attract higher interest rates
- Because you own the car you’ll be responsible for repairs and maintaining the car
- The monthly payments for the car can be higher than other forms of finance, but this depends on the term that you choose and interest rates
Changing your car on a traditional loan
A traditional car loan means that you own the car outright once the money hits the dealership’s/private seller’s account from the lender. So, if you’re looking to change your car then your option is to sell the vehicle and use all or part of the cash to fund your next vehicle.
Nevertheless, you’ll have to remember that the loan agreement with the lender still stands. If you sell the car, you may want to put some of it aside to go towards paying the monthly payments for your loan.
Which type of car finance is right for me?
Now that you know how the different types of car finance work, why not see which one is right for you with our summaries below?
When you should choose PCP car finance
- If you want to drive a new car every few years and have the option to own it at the end
- You want to be flexible about the amount of money you put upfront as a deposit
- You want the option of new and used car finance
When you should choose HP car finance
- If you want to own the car you’re financing at the end of your agreement
- You don’t want to pay a large balloon payment in order to own the car
- You want the option of new and used car finance
When you should choose car leasing
- If you want to drive the latest car every few years
- When you don’t want to own the car at the end of your agreement
- If you want to drive brand-new cars that come with the manufacturer’s warranty
When you should choose a personal car loan
- If you have good credit, in which case you can usually get better rates than the ones offered by a car dealership
- If you want to spread the monthly payments for your car over a longer term
- If you’ve already saved up some money to put towards your car, but can’t wait to meet the purchase price
Want a side-by-side comparison of all car finance options to help you pick the best one for you? Head over to our other guide explaining which finance is best.
Alternatively, if you want more information about car finance and leasing, head over to our guides page.
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