Car finance explained: how does it work?

Car finance can be confusing – full of complicated jargon. But it can also be key to a great deal on your new car. Here’s our guide

BuyaCar team
Mar 5, 2021

Asking a car salesperson about finance will almost inevitably mean a response peppered with confusing-sounding acronyms. PCP, GMFV, HP, APR: what does it all mean? If you’re feeling pressured and confused it could mean you sign up to a form of finance that isn’t right for you. But the reality is not that complicated. And of course a responsible car salesman won’t push you into a deal you don’t understand.

But an understanding of the various types of car finance and the terminology associated with them is useful, especially as different finance methods will work for different circumstances.
For example, if you want to ensure low monthly payments – but still want the option to buy the car at the end of the contract or hand it back – Personal Contract Purchase (PCP) finance could well be the right move for you.

However, if the lowest overall cost is the main aim rather than low monthly payments, then Hire Purchase could suit you. And if you simply want the lowest monthly payments and don't want the option to own the car, look into leasing, known as Personal Contract Hire (PCH).

This back-to-basics guide will explain in simple terms how car finance works and the differences between the different variations, so you can be sure which type of finance is best for you.

Once you’re happy with the basics, then you can explore your finance options further, with more detailed articles about the car finance options available to you, or you can click below to search for the latest finance deals across thousands of cars, get your head around no-deposit deals or search for the best used cars for £100 per month.

What is car finance?

Finance helps to make cars more affordable by splitting the cost into a deposit and a series of monthly payments. This means you can effectively borrow money to pay for a car and then repay this in instalments to the finance company.

Traditional car finance - known as Hire Purchase (HP) - is a bit like a bank loan, which means you can buy a new car without having to save until you have enough cash to buy it outright.

Meanwhile, another option - Personal Contract Purchase (PCP) finance - provides lower monthly payments, so you can get a newer or more desirable model for your monthly budget, though you have to make a large optional final payment at the end of the contract if you want to buy the car rather than hand it back to the finance company.

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. So, the more you borrow and the longer the contract, the more interest you'll have to pay.

Who provides car finance?

Specialist lenders supply car finance. Some of these are part of a car company itself, while others form part of a bank or another financial institution.

These companies work with manufacturers and retailers help drivers fund their next vehicle. When you successfully apply for finance, the car is sold to the finance company and delivered to you. You then make payments to the lender.

Car finance payments


The deposit is an upfront payment made before you receive the car. This goes towards the cost of the vehicle and therefore you don't ever get it back. You may have the option of paying no deposit, but be aware that the smaller the deposit you put down, the higher your monthly payments - and the more interest you'll pay (except where interest-free credit - also known as 0% APR - is available, as no interest is charged then).

This means that if you choose a £10,000 car and put down a £1,000 deposit, you’ll owe £9,000. Meanwhile, if you increase the deposit to £2,000 that would reduce how much you owe to £8,000, which in turn would shrink down your monthly payments and the amount of interest you pay.

Monthly payments

Once you've paid a deposit - or not if you go for a zero deposit option - you then make a series of monthly payments for the length of the contract, which include a little interest on top. These are usually spread over two to five years, depending on the type of finance you go for.

Payments have to be made in full and on time, or you risk having the car taken back by the lender. If you encounter financial difficulties, or expect that you will in the near future, it's best to flag this as soon as possible with the finance company as they may be able to help - potentially by reducing your payments for a couple of months or lengthening the contract to lower your instalments, for instance.

As 'defaulting' - missing any of your payments - can seriously affect your credit score, making it more difficult and more expensive to get finance in future, it's wise to try not to overstretch yourself. However, if you do have a low credit score, check out our roundup of the best bad credit finance deals, to make sure you're getting the most for your money.

What happens at the end of a car finance contract?

Sign up for a Hire Purchase deal and once all of your payments have been made, you automatically own the car. With PCP finance, however, you don't own the car unless you make all of the monthly payments - plus the optional final payment.

The optional final payment - also known as the balloon payment - is a pre-agreed figure that roughly equals what the car is worth at the end of the contract on a PCP deal. If you want to own the car, you have to pay this - or you can take out a new finance contract to cover the cost of this. Alternatively, you can hand the car back with nothing left to pay, provided it's in good condition and you've stuck to the mileage limit agreed at the start of the contract.

Read our guide to what happens at the end of a PCP finance contract to understand all of your options.

It’s important to consider the right type of finance for you, before you sign up, to ensure that the version you choose suits your needs and that you understand what you need to pay and when.

Car deals under £200 per month

What types of car finance are there?

Different types of car finance have developed to suit a range of budgets and circumstances. These are the most popular types:

Hire Purchase (HP) / Conditional Sale

Hire Purchase - also known as 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 you make, is split into a series of equal monthly payments, which include interest.

Once you’ve made all of the payments, you will own the car and you're free to sell it, to part exchange or you can simply keep driving it. More details

How HP finance works

1. Deposit and delivery

  • Place a deposit to reduce how much you owe
  • In some cases zero-deposit options are available

2. Monthly payments

  • Pay for the rest of the car with a series of fixed monthly instalments

3. You own the car

  • Once you've made the final payment, the car is yours and you can keep it or sell it

Personal Contract Purchase (PCP)

This is the most popular type of car finance because it combines low monthly payments with the flexibility to buy the car or hand it back.

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

How PCP finance works

1. Deposit & delivery
  • The larger the deposit, the lower your monthly payments
  • A no-deposit option is often available
2. Monthly payments
  • A fixed payment is due every month for the rest of the agreement
  • You only repay part of the car's cost, keeping instalments low
3. Buy / return / upgrade
  • Pay the remaining balance or refinance to keep the car
  • OR Return the car and owe nothing
  • OR Trade-in for another vehicle if the car is worth enough

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 car leasing works

1. Initial payment

  • Initial payment is usually the equivalent of 3 to 12 monthly instalments

2. Monthly payments

  • Fixed monthly payments throughout the agreement

3. Return the car

  • Once all payments are made, you return the car.

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.


Read more about:

Latest advice

  1. Leasing: How to choose the right mileage allowance

  2. Panoramic sunroof pros and cons

  3. Car finance: who can be a guarantor?