How does car finance work?

For many, financing a car is the best way to make the purchase affordable to them.

Breaking down the cost of a new car into bite-sized monthly payments is a very viable way to pay for a vehicle - but how exactly does it work?

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Car finance: explained

The general definition of car finance would be to purchase a car, not outright, but rather paying for it over time through affordable monthly payments.

This means that you don’t need £1,000s upfront, and can instead obtain a new car quicker and easier.

Car finance is made possible through entities called Lenders - essentially, these lenders will front the total cost of the car when you purchase it, and you pay them back over time.

Breaking down car finance deals

There are a few components that make a car finance deal work, each affecting the agreement in various ways:

Cash Price - this is the cost of the car before any interest is applied, and is the starting point of any car finance agreement.

Monthly Payment - this is the number everyone looks for when considering a finance deal on a car.

The monthly payment is what you’ll pay until the end of the finance agreement to pay off the vehicle, and will be the same amount each time.

There are several factors that can affect how much this monthly payment will cost, such as the deposit, term and rate of interest.

Deposit - this is the amount of money you want to - or are able to - put down towards the car at the start of the finance agreement.

The larger a deposit you can put down, the less of an amount there is to finance overall, and your monthly payments will be cheaper as a result.

The deposit can be cash or you can part exchange your outgoing car - however, you will need to own the car outright or the vehicle needs to be worth more than any outstanding finance when part exchanging.

If you try to part exchange a car which is worth less than the outstanding finance, you’ll be in what’s called negative equity, and you won’t be able to use it towards your finance deposit.

Manufacturer Deposit Contribution - when buying a brand-new car, you may come across a deposit contribution which is supplied by the manufacturer as an incentive.

This typically gives you a helping hand towards making the monthly payments cheaper in the same way a regular deposit does.

Amount to Finance - this is the Cash Price minus any deposits made, and is the amount that will be financed through monthly payments.

The amount to finance will be susceptible to interest costs, and the monthly payments will reflect this (assuming you’re not on a 0% deal).

Interest Payable - most finance agreements are affected by interest, with a specific rate of interest set at the start of the deal - with the higher the rate of interest resulting in higher monthly payments.

This figure represents the total cost added to the agreement through interest.

Total Amount Payable - put simply, this is the Cash Price of the vehicle plus the Interest Payable, making the total cost of the finance agreement once all payments have been made.

Term/Duration of Agreement - this number represents the total amount of months the finance deal will be spread across.

You can help make your monthly payments cheaper by extending the amount of months you pay over, while a shorter term will make them more expensive.

Some components of a finance deal are only relevant to certain car finance types, with the following only applicable to Personal Contract Purchase (PCP):

GMFV - the Guaranteed Minimum Future Value, this is a figure with two purposes.

Firstly, it’s the estimation of what the car will be worth once all the monthly payments have been made in a PCP deal - this estimation is mostly based on how old the car will be and the mileage it will have done.

Secondly, the GMFV acts as the optional final payment that can be made to make the car yours.

Mileage - at the start of any PCP deal, you will agree to a mileage amount you believe you’ll travel in the car during the term of the agreement.

This is typically broken down into an annual mileage figure, adding up to a total figure for the agreement overall - if you go over the total mileage set for the contract, you can be susceptible to extra charges.

Excess Mileage Charge - if you do go over the set mileage set for your PCP agreement, then you can be charged per extra mile you have driven.

This is charged at a rate of pence-per-mile - however, such charges are only applicable if you are looking to hand the car back when the agreement ends.

Car finance options

When considering car finance, you’ll likely come across several types of finance options.

While there are many similarities between them, car finance types can differ enough that you’ll need to decide which one works best for you.

Hire Purchase (HP)

HP is one of, if not the most common finance type you’ll come across, especially for used cars.

It could also be argued that HP is the most straightforward of finance types, and is broken down as such:

Pay an upfront deposit
Agree a contract length
Make your monthly payments over the set number of months
Once all payments have been made, you will own the car

Benefits of HP include:

Perfect for those who want full ownership
A useful finance type for those with poor credit
No mileage restrictions or extra related charges

What to consider:

Monthly payments are higher compared to that of PCP, as you’re financing the full cost of the car
Won’t be the legal owner of the car until all payments are made
There’s no option to hand the car back other than terminating the agreement early

Learn More About Hire Purchase

Personal Contract Purchase (PCP)

PCP finance is a popular option for those purchasing a brand-new car, and is a flexible finance type due to the choices available at the end of the contract.

What makes PCP finance stand out is that much of the car’s value is tied up in an optional final payment, commonly referred to as the GMFV - this makes monthly payments typically cheaper than with an HP deal.

A PCP agreement can be broken down as such:

Make an upfront deposit (though sometimes you’ll be able to do a nil deposit PCP agreement if needs be)
Agree a contract length
Agree an annual/contract mileage
Make your monthly payments till the end of the agreement

Once all monthly payments have been made, you then have three choices:

Pay the GMFV and take full ownership of the car
Use any equity in the car to part exchange for a new vehicle
Hand the car back and walk away

Benefits of PCP finance include:

Cheaper monthly payments compared to HP, as you’re not initially paying towards the full value of the car
Perfect for those who like to chage cars frequently
Offers added flexibility

What to consider:

Don’t take ownership of the car until all payments are made - including the GMFV
Charges can apply if you exceed your contracted mileage
Can also be charged for excessive wear and tear
Not usually a viable finance option for those with poor credit

Learn More About Personal Contract Purchase

How does a personal car loan work?

A car loan is different to the likes of HP and PCP in that you directly loan the money to pay for a car, and then pay the lender back.

You apply for a car loan through your bank or a car finance lender, and once approved, the money will be sent straight to your bank account.

From there, you’ll pay the lender or bank back through monthly payments.

Benefits of a personal car loan:

You’ll own the car as soon as you buy it
No mileage restrictions or concerns about wear and tear
No deposit is needed, nor are there any big final payments

What to consider:

As you’ll own the car from the start, there’s no option to hand it back; you’ll need to part exchange or sell it
Interest rates can be considerably high if your credit is poor
You’ll need to plan the time you want your money to be deposited to your bank account and when you buy the car

How can I apply for car finance?

For car finance options such as HP & PCP, you will typically apply for finance directly through the dealership you’re buying the car from - especially if it’s a brand-new car.

You’ll be able to do this in the dealership itself, or you can sometimes start your finance journey ahead of looking for a car and get pre-approved for finance, like you can here at Stoneacre.

The application process for car finance requires an assortment of details from your side, including information on your address and employment history.

While the likes of our online form performs a ‘soft search’ of your credit profile, and won’t affect your credit score, the final part of any finance application is to do a full ‘hard search’.

Once the finance is in place, you can finanlise the paperwork to make the car yours.