How Does Car Finance Work? A Helpful Guide

How does car finance work 2 opt2

You’ve got your eye on that amazing new car. It’s red or blue, it’s shiny and it suits your personality to a tee. However, without the money to buy it upfront, it’s just a pipe-dream, isn’t it?

Well, actually… no! There are other ways to finance your purchase, providing you borrow sensibly and are aware of the risks involved.

But how does car finance work? And, most importantly, is it worthwhile? Here’s a guide, detailing what car finance is, plus the benefits and drawbacks involved.

What is Car Finance?

Of course, it’s always preferable to purchase a car outright. Avoiding debt is a shrewd move, so if you can save up for your car instead, it’s advisable to do so.

However, if you’re not in a position to save that level of money, but badly need a set of wheels to get from A to B, car finance makes good sense.

Quite simply, car finance helps you spread the cost of buying a new or used car. You won’t have to pay the full amount upfront – instead, you’ll pay an agreed monthly fee.

This enables you to get your hands on a car, without forking out thousands in one lump sum.

How Does Car Finance Work?

So, how does car finance work, precisely? Well, every product is different, but generally speaking, they operate on the same premise.

The finance company purchases the car on your behalf, then you’ll repay the value over a set period of time, plus interest.

All car finance agreements are set for duration of time, which is often around three to four years. During this time, the car is still legally owned by the finance company – not the motor dealer and (please note) not you.

At the end of the agreement, providing you’ve made all the repayments, you’ll become the legal owner of the car.

The only exception to this rule is if you selected a rental / hire agreement. If this is the case, the car is returned to the finance or car-hire company.

Questions to Ask When Getting Car Finance?

Like any form of loan, it’s important to get the right information before committing. Here’s a list of questions you should be asking.

What sort of car finance product is best for me?

You’ve asked ‘how does car finance work’; now it’s time to ask ‘which form of financing is right for me?’ – as there are several options available. Here’s a quick run-through of the most common options.

1. Hire Purchase/ Conditional Sale

Hire Purchase is a straightforward finance agreement, with the option to own the car outright at the end of the contract.

You’ll normally pay fixed costs, and your finance is secured against the car purchase, which allows lenders to be more flexible with their terms and conditions.

You’ll be the registered ‘guardian’ of the car during the agreement, but the financial company legally own it until you’ve repaid the full amount of the loan.

2. Personal Contract Purchase (PCP)

PCP works in a similar way to a hire purchase agreement, but is more suited to those who want lower monthly payments.

The big difference is that the value of the car at the end of the agreement is estimated and deferred.

This deferred sum is based on several different factors, including the age of the car at the end of the agreement, and how many miles it is estimated to have driven.

Deferring this future value to the end of the agreement means your monthly payments are lower – plus you can choose not to own the car at the end of the agreement, and trade it in for a new model instead.

3. Lease Purchase

A lease purchase is similar to a conditional sale agreement. However, your deferred sum must be paid in a lease purchase – whereas on a PCP, it’s optional (which keeps costs down).

As a result, lease purchases are better suited to those who want to buy more expensive vehicles.

4. Personal Leasing

Unlike the other options, personal leasing means the car will never belong to you – you’re simply ‘borrowing’ it for a fixed fee. However, the servicing and maintenance of the vehicle is included in the price, which may appeal to some.

What’s the interest rate?

The interest rate (APR) is the amount you’ll pay in addition to your repayments. This figure may vary, according to the current rate of interest, your credit history and the offers available at the time.

It goes without saying that you should shop around to get the lowest interest rate on your car financing deal – as this means your payments will be reduced. Not sure what APR is? Read this helpful article on What is APR?

How Much Can I Afford To Borrow?

It’s never a good idea to agree to a monthly payment that you cannot afford. This is especially the case if you’ve already got a bad credit rating – although there are car finance for people with bad credit, this is not a good idea.

Make sure you know exactly what you’re committing to when agreeing the purchase. There are several online tools such as this calculator to help you calculate what monthly amount you can realistically commit to.

How Long Am I Tied Into This Agreement And How Much Will I Owe?

It’s important to know how long you’ll be expected to make monthly payments, so you can plan your finances accordingly. Work out what you’ll have to repay in total, as this will give you an idea of whether the purchase is worth it or not!

For example, your car financing company may offer you £7,000 against the new car; with an APR of 6.9%, which you’ll need to pay back within 3 years.

That doesn’t sound like much, does it? However, it’s actually £7,769.51, which is nearly £770 in interest. Always make sure you know exactly what you’re committing to when agreeing the purchase. 

How Does Car Finance Work? The Risks Involved

Unless you pay outright, all forms of financing carry risk. It’s important to be aware of these risks before making a decision.

  1. You won’t own the car outright. It’s important to remember that the car is not yours until you’ve fully repaid the loan. If you get into financial problems, you won’t be able to sell the car to raise cash funds. 
  1. You’ll be paying more. You’ll be paying interest as well as repaying the value of the car -which means you’ll pay more in the long run. In most instances, this equates to hundreds of pounds. If you can’t afford it – don’t do it. 
  1. Damage can affect the cost. If you choose a personal contract plan, any damage to the car will affect its deferred value. If you want to trade the car in and start again, this will have impact on its value, and means you’ll have to pay more for another vehicle. 
  1. Mileage limits. Many car financing deals have mileage limits, which means you’ll be restricted on how far you can travel. If you go over it, this will affect its deferred value.

Do You Need Car Financing?

So, how does car finance work, really? Always bear the following in mind when deciding whether you need to borrow or not.

Loans are designed to make money for financing companies. Despite clever advertising, they’re not created to support you financially!

However, on occasion, you may need to use car financing, particularly if you need a car for your job. If you do need to get a loan, make sure you shop around.

Over to You

Have you used a loan to finance your car purchase? Did you feel well informed when you agreed to the contract, and how did you find the monthly repayments? In retrospect, would you choose to finance your purchase differently? We’d love to hear about your experiences.

This post is part of the Debt Management series, you can read all posts in the series here.








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