Car Finance Explained: What Is Financing A Car?

Chloe Murphy 7 minutes Published: 26/08/2021

Cars are one of those prized possessions that we actually use in our daily lives. They provide us with the comfort and convenience of getting around easily - but unfortunately at a cost!

When you finally find your dream car, it can be a punch to the gut realising that to own your car straight away, you actually have to pay for it there and then.

But not everyone can afford to splash out thousands of pounds all at once, and it’s become more and more popular for drivers to use car finance as a result. It can seem complicated compared to buying outright, but it’s actually fairly simple, and there are a number of options to choose from. 

In this guide to car finance, we explain what exactly car finance is, the best ways to finance a car, and the main pros and cons. 

What is car finance?

If you’re not planning on paying cash for a car or buying a car with your credit card, you’ll typically pay for it through a finance package. This means that rather than submitting one full payment, the full cost of your car will be split up into monthly payments over an agreed term. 

Since it’s not feasible for most people to pay the full cost upfront, finance offers an affordable way to get your own car, with a payment plan that suits you.

What are examples of car finance?

With car finance, there are a few main options for you to choose from. 

You can get a deal through Personal Contract Purchase, Hire Purchase, Car Leasing, Lease Purchase, or a Personal Loan. 

Our individual posts on these give you a detailed look at all the ins and outs, so here’s a quick recap of how they work: 

  • Personal Contract Purchase (PCP) - You typically pay a deposit and  monthly payments over the contract term, pay the balloon payment to purchase, or trade-in for your next car on a new PCP deal. As there’s no obligation to buy, you have limitations like an annual mileage. Read more in our post “What is PCP finance?”
  • Hire Purchase (HP) - You pay a deposit, then set monthly payments that contribute towards the total cost of the car. At the end of your contract, the car’s yours. Few limitations as you’re working towards ownership. See our car hire purchase post for more.
  • Personal Loan option - You take a loan from your bank and buy the car outright. Then you make your repayments to your bank. No mileage limit. We've gone through how to get a car loan if you're interested.
  • Lease deal - Also referred to as Personal Contract Hire (PCH) or Business Contract Hire (BCH), you pay a deposit, a monthly fee ‘til the end of the term, and then hand the car back. You’ll have a mileage limit, but a brand new car with warranty, and no MOT requirements (assuming your deal is 3 years or less). We’re experts in leasing, so have written a full guide on “how does car leasing work?”
  • Lease purchase - This works like leasing, except you have to buy the car at the end of the deal with a balloon payment, and no option to hand it back.

It’s not easy to decide between them all, so check out our comparison posts for the options you’re most interested in:

Pros and cons of using car finance

Getting a new car through finance is increasingly popular, as it makes driving a car much more accessible. You can even finance a used car, with PCP and HP offering lower monthly payments on older second hand models.

Deciding whether to finance your car is a big decision, and the pros and cons can vary depending on each type. Here, we’ve rounded up the general advantages, and disadvantages to financing your car.

The advantages of car finance

There are some attractive advantages to financing your car, including:

  • Affordability - Almost any form of car finance you take out is making it more affordable than paying the total amount for your car upfront. The monthly cost will be higher with options like HP as you’re paying towards the entire value of the car, but cheaper with PCP and leasing as you’re only paying for the depreciation.
  • Flexible deposits - In most cases you can work out a deposit with the car dealer to suit your budget. You can commit to a larger deposit on your finance agreement, which reduces your monthly payments, or with PCP or HP, there may be a no deposit option if paying upfront is an issue. Some manufacturers even offer deposit contributions as incentives.
  • You don’t have to own the car - If thoughts of depreciation and selling your car stresses you out, car finance options like leasing and PCP are great choices. You benefit from lower payments as you’re not going to own the car, and just hand your car back when the contract’s up. 

The disadvantages of car finance

On the flipside, there are some drawbacks to car finance:

  • You don’t own the car - Even with HP where you’re paying towards owning the car, you aren’t legally the owner of the car ‘til you’ve submitted that final payment. Similarly, with PCP you only own the car if you choose to pay the lump sum at the end of the contract. 
  • Potential charges - As the lender retains ownership during your contract, options like PCP and leasing hold the risk of additional charges. You’ll typically have an annual mileage allowance, which you’ll face fines for going over. Since the car isn’t your property, you also have to keep it in good condition, and within the limits of reasonable “wear and tear” until the end of the agreement. 
  • Interest rates - The APR (annual percentage rate) will vary depending on your credit rating, but if your credit history is poor you could end up paying higher rates due to the risk you pose. 

What do I need to be accepted for car finance?

Generally, you’ll need a decent credit score to be accepted for most finance options. However, different finance companies will have their own criteria that they require drivers to meet, so being rejected for one doesn’t mean you’ll be rejected for all. We’ve done a general post on what credit score is needed to buy a car.

It’s best to start off by checking your credit report through sites like Experian, Credit Karma, Equifax, and ClearScore, as it’ll give you a better idea of your eligibility. 

You can still get finance with bad credit ratings, but you may end up paying more as you pose a greater risk to the lender. Those with good credit scores will get the best deals, as finance companies will be more comfortable knowing you’ll make your monthly repayments on time.

For example, you don’t always need good credit to lease a car, but you will likely be offered pricey deals on cheaper models. Some brokers allow you to get round failing your car lease credit check if you can provide a guarantor for your car lease.

“My credit score is dandy. What documents do I need to buy a car?” I hear you ask. To apply for car finance, you’ll need to supply:

  • Personal details, such as date of birth, marital status and address
  • Employment details and history for the last 3 years
  • Bank details
  • Driver’s Licence 

How to get the best car finance deals

Car finance deals are ideally there to simplify things, but this doesn’t mean you should just go with the first one you find. There’s a lot to think about and consider to make the most of your finances.

  • Check the interest - The APR might differ significantly across the different types of car finance, so it’s a good idea to check this out and see how it impacts the deal and car payments you’re looking at over your specified timeframe.
  • Look online - It might seem easiest to run down to your local dealership, but browsing plans online can give you a better idea of what you should be paying, and what type of car you can afford.
  • Don’t rush into deals - Particularly when you’re at a dealership, it’s not uncommon to get caught up in the excitement and sign away on a deal you’re not 100% sure on. Take your time to work out the finances, and get a deal you can afford.
  • Future thinking - It probably sounds great in the moment to take a longer payment term and have low monthly costs, but you’ll end up paying more interest and a greater overall amount at the end of your loan term.

Car financing won’t be for everyone, but there’s certainly a lot of advantages. You can get a car on a budget without saying goodbye to half of your savings, and lenders will often help find a contract that suits you. 

Before you get started, our “should I get a car on finance” article walks you through all the questions to ask yourself to decide, from whether you even need a car, to whether you can afford it.

If you think you’d prefer leasing in the lease vs finance battle, then Lease Fetcher is here to help. We are a car lease comparison site which gathers deals from leading UK brokers so you can compare personal car leasing and business car leasing deals with ease!