Car finance explained

No jargon and no confusion. Car finance explained in our back-to-basics guide

BuyaCar team
Nov 20, 2018

Speak to a car dealer about finance and you're unlikely to have to wait for ten seconds until the jargon starts flying around.

And if you’re not up to speed with PCP, GMFV or APR, then you could end up signing an agreement that’s not right for you.

This is a back-to-basics guide to how car finance works. It’s guaranteed to be jargon-free and understandable, even if you’ve never taken out car finance before.

Once you’re happy with the basics, then you can explore your finance options further, with more detailed articles about the choices available to you, or click below to search for current finance deals.

 

What is car finance?

Finance helps to make cars more affordable by splitting the cost into a series of monthly payments. You effectively borrow money to pay for a car and then repay this in instalments to the finance company, making finance a bit like a bank loan. In most cases, lenders charge interest for providing finance. The amount of interest that you pay increases with the value and length of the finance agreement.

 

Who provides car finance?

Specialist lenders supply car finance. These companies work with manufacturers and retailers such as BuyaCar to help drivers buy their next vehicle.

When you successfully apply for finance, the car is sold to the finance company and delivered to you. You will then repay the lender.

 

Car finance payments

Deposit
You may have the option of paying no deposit, but most buyers put some money down as it can reduce the interest rate. The deposit is paid before you receive the car and goes towards the vehicle cost, so you don’t get the money back.

If you’re buying a £10,000 car and put down a £1,000 deposit, you’ll owe £9,000.
If you increase the deposit to £2,000, then you’ll only owe £8,000, which will reduce the amount of interest that you pay, as well as your monthly instalments.

Monthly instalments
After paying a deposit (or not), the remainder of your car finance is repaid in fixed monthly instalments, which also include interest costs. These are usually spread over a period that lasts between two and four years.

Payments have to be made in full and on time, or you risk having the car taken back by the lender.

 

What happens at the end of car finance?

Once all of your payments have been made, some types of finance leave you owning the car. In other cases, you won't have paid for the car, so you'll either have to return it or buy it for an additional amount.

It’s important to consider the right type of finance for you, before you sign up, to ensure that you’re left in the position that you want to be in.

 

What types of car finance are there?

Car finance has developed to suit a range of budgets and circumstances. These are the most popular types:

Hire Purchase (HP) / Conditional Sale

Hire Purchase, or Conditional Sale, is the most straightforward type of car finance and is available for virtually any new or used car.

The cost of the car, minus any deposit, is split into a series of equal monthly instalments, which include interest.

Once you’ve made all of the payments, you will own the car. More details

 

 

Personal Contract Purchase (PCP)

This is the most popular type of car finance because it combines low monthly payments with flexibility.

You’ll be able to pay a deposit but it’s not always required. You’ll then make fixed monthly payments until the end of the agreement.

These payments are more affordable than with some other types of finance because they don’t cover the full cost of the car. Instead, you’re only paying for the value that the car is expected to lose during the finance term.

Your lender estimates how much the vehicle will be worth at the end of the agreement and then works out the difference between this future value and its current price. Your monthly payments, minus any deposit, will cover this difference.

Part of this process involves setting an annual mileage limit. If you drive further, then you risk penalty fees.
At the end, you have at least two options:

  • Return the car to the lender. You’ll face penalty fees if there is excessive damage, according to trade guidelines, or if you have gone over the mileage limit
  • Buy the car for its estimated future value (also known as the guaranteed minimum future value, or GMFV). If you can’t pay the full amount in one go, this can be refinanced, spreading the cost over another series of monthly payments.
  • If your car turns out to be worth more than its estimated future value, then you’ll also be able to trade it in for another model with any good car retailer. They will pay off your finance, and put the difference towards another car.
    You could also sell the car with the agreement of your lender and pocket the difference. More details

 

 

Leasing or Personal Contract Hire (PCH)

Leasing isn’t strictly car finance because it’s a long-term car rental.

You’ll pay an initial rental fee (which you don’t get back), followed by fixed monthly payments.

At the end of the agreement, you return the car and there’s no option to keep it.
A mileage limit applies to lease agreements, so you will face penalty fees if you go over this limit or if there is excessive damage on the car, according to trade guidelines. More details

 

 

How is car finance interest calculated?

The interest that you pay on car finance is calculated as a proportion of the amount that you borrow. The higher the rate, the more you’ll be charged.

As you repay your finance, your remaining debt will decrease, and so will your monthly interest charges. This is why it’s cheaper in the long run to pay your finance off quickly.

The interest rate that you’re offered will depend on the value of the car that you’re buying and your personal circumstances. If you’ve got a history of repaying debt and are in a stable situation, with a steady job, then lenders will assume that you’re likely to repay the finance in full and offer you a lower rate.

Borrowers who have a history of money troubles usually pay a higher interest rate, as lenders assume that there’s a higher risk that they won’t meet their repayments.

 

Comparing car finance

Monthly finance repayments include interest, as well as additional fees imposed by lenders.

That’s why every car finance agreement must include an Annual Percentage Rate (APR) figure. This takes into account all fees and interest, and converts them into a standardised number that can be used to compare quotes.

Because every APR figure is calculated in the same way, you can be sure that the quote with the lowest number will be the cheapest form of finance.

It’s also worth looking at the total amount payable, which should be included with every finance quote. This adds up the deposit, monthly payments and interest charges so you can see the cost of extending an agreement from two to three years, for example.

 

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