Car Finance Explained – How Does Car Finance Work?

What is Car Finance?

The term ‘car finance’ covers a range of options that enable you to borrow money which you repay over an agreed period to buy a new or second-hand car instead of purchasing it outright. At the end of the finance agreement, you may have the option to buy the car outright or hand it back to the dealer.

How Does Car Financing Work?

When entering a car finance agreement, you’ll agree to the terms and conditions of the contract with the lender, including how long you’ll be paying for the car, the amount to pay, and any additional required criteria, such as annual mileage allowance. The lender will provide the money to cover the cost of the car, at which stage you may be required to pay an initial deposit and then your regular agreed repayments in the following months.

When the contract ends, depending on the finance option you’ve taken out, you will either own the car outright or will have several options regarding the remaining balance due on the vehicle. You can either give it back to the dealership, pay the remaining balance in full or use any additional equity (calculated as current value of the vehicle less any existing balance due on the vehicle) to form part of a deposit on a new car finance deal if you want to.

What Are the Different Types of Car Purchase / Finance?

Bought Outright

When you purchase a car outright, you gain full ownership of the vehicle from the date of purchase. Opting for an outright purchase eliminates any ongoing financial obligations once the transaction is finalised, ensuring you are not liable for additional payments.

Additionally, no potential financial implications are involved in the future should you decide to sell the car at a time you choose.

The benefit of buying the car outright is that the vehicle is yours to keep as soon as the transaction is complete, with no further payments required.

Hire Purchase Loan (HP)

A Hire Purchase Loan is a widely used car buying and lending option and is offered by most dealerships. In a Hire Purchase Loan agreement, you, as the customer, enter a contract with a finance company. The finance company effectively purchases the vehicle from the dealership and then ‘hires’ the vehicle to you for a specified timeframe, with monthly payments based on an agreed cost. There is usually a deposit to pay upfront (typically the equivalent of 6 x monthly payment amount). The hire period is typically between 24 and 48 months, with longer time periods resulting in lower monthly payments. In essence, you are paying off a loan secured against the vehicle.

Once the Hire Purchase Loan is repaid in full, you can either purchase the vehicle by paying an additional fee known as the ‘Option to Purchase’ fee, or you can choose to return the car to the finance company. It is important to note that you only legally own the vehicle once the total loan amount is repaid. However, you can gain vehicle ownership once the loan is fully settled.

Personal or Business Contract Purchase (PCP or BCP) [Has Balloon]

A Personal or Business Contract Purchase (PCP/BCP) is similar to Hire Purchase, where you enter a finance agreement by paying fixed monthly instalments over an agreed period. Usually (but not always), you will pay a deposit, and at the end of the fixed period you will have the option to either pay the final payment or return the vehicle to the dealership. This optional final payment is often referred to as the balloon payment or Guaranteed Minimum Future Value (GMFV)  is set when the agreement is made. It represents the finance company’s prediction of the vehicle’s value at the end of the contract.

When opting for a PCP or BCP, you must agree to a ‘mileage allowance’ based on your expected usage. This mileage allowance directly impacts the GMFV and consequently affects the monthly repayments. If you exceed your expected mileage allowance, at the end of the term the vehicle may be worth less than the GMFV, so finance companies typically have an “additional mileage charge” to cover this additional depreciation.

It is important to note that you must maintain proper insurance coverage and keep the vehicle in good, roadworthy condition throughout the duration of the agreement.

Contract Hire (Personal Contract Hire (PCH) or Business Contract Hire (BCH) [No Balloon]

When it comes to a Contract Hire agreement, no balloon payment is involved, which means there are no additional financial obligations for you, the customer. This lease agreement structure is designed to keep the customer’s responsibilities focused on making the agreed-upon regular payments throughout the lease term. This setup offers a more predictable and straightforward financial arrangement without surprises or lump-sum payments. The monthly cost and hire period is set, and at the end of the agreement the vehicle is returned to the dealership.

Personal or Business Loan

A Personal or Business Loan is a borrowing arrangement in which an individual obtains a lump sum of money from a financial institution to fulfil personal needs, such as acquiring a vehicle. The loan amount is repaid through regular fixed monthly payments or instalments, accompanied by a fixed interest cost. The repayment terms will simply be based on the amount you wish to borrow, the interest rate, and the length of time you want the loan to be based over. As such, anticipated mileage or predicted future value of the vehicle do not impact the monthly payment amounts.

When utilising a Personal or Business Loan for purchasing a vehicle, there is no requirement for a deposit. This means you effectively own the vehicle outright from the moment of the transaction. However, it’s important to note that you still carry a financial obligation to the financial institution that provided the loan.

Conditional Sale [May Have Balloon]

A Conditional Sale agreement shares similarities with a Hire Purchase. Still, there is a significant distinction—the customer commits to becoming the vehicle’s legal owner once all repayments have been completed. This fundamental difference sets it apart from a Hire Purchase agreement, where the customer can ultimately decide at the end of the finance term whether they want to take legal ownership. Additionally, balloon payments may also be utilised in Conditional Sale agreements. Conditional Sale transactions typically involve three parties and are available to both private individuals and businesses.

One notable variation between Hire Purchase and Conditional Sale is the absence of an ‘Option to Purchase’ fee in Conditional Sale agreements. Unlike Hire Purchase, where an additional fee is required to exercise the option to purchase the vehicle, in a Conditional Sale, the customer is obligated to purchase the car at the end of the agreement outrightly.

Lease Purchase [May Have Balloon]

A Lease Purchase is a financing option that differs from Hire Purchase or Conditional Sale through its unique payment structure. Instead of a traditional deposit, Lease Purchase requires several payments made in advance. The payment structure resembles a lease agreement, setting it apart from the other financing options. Additionally, Lease Purchase agreements may include the opportunity to have a balloon payment. This allows the customer to take ownership of the vehicle upon completion of the agreement.

Since a Lease Purchase is considered a purchase plan, the payments are not subject to Value Added Tax (VAT). At the end of the agreement, the customer is entitled to take title and ownership of the vehicle. This means that upon fulfilling the terms of the Lease Purchase agreement, the customer gains full ownership rights over the car.

Finance Lease [May Have Balloon]

A Finance Lease is a traditional lease agreement where the customer agrees to ‘rent’ the vehicle for a predetermined period. At the end of this period, the customer has two options: they can either choose to sell the car or enter a second “hire” period. One notable feature of a Finance Lease agreement is its flexibility, allowing the terms to be customised with or without a balloon payment.

A Finance Lease is particularly suitable for VAT-registered businesses as it offers a flexible leasing arrangement without transferring vehicle ownership. This makes it a preferred option for businesses that require vehicle use without the need for ownership.

The flexibility of a Finance Lease agreement extends to the ability to include or exclude a balloon payment. This means that depending on the specific agreement, the customer can incorporate a larger final payment at the end of the lease term, which can impact the overall cost and monthly payments. Including or excluding a balloon payment enables the lease agreement to be tailored to align with the customer’s financial preferences and requirements.

Will I Be Accepted for Car Finance?

When thinking about applying for car finance, you should think about whether the car you are considering realistically suits your budget – both now and for the duration of your finance agreement. You can see the latest examples of finance offers on our new car pages, or if you’re interested in purchasing a used car, we have an interactive calculator you can utilise once you’ve clicked on a car you like. This will help you to find out what monthly payments for your desired car might look like. Bear in mind that you will have additional vehicle ownership costs such as insurance, road fund license and ongoing maintenance. Your credit score is also an important factor and will determine what finance options will be available to you. If you have a great credit rating, you are likely to be accepted by funders with lower interest rates, while if you have a poor credit history, you may still be offered finance, but it may be with higher interest rates. Contact our sales team for further information on whether you are likely to be accepted for car finance and current interest rate information.

Which Car Finance Option is Best for Me?

With several options, it can be hard to know which car finance option will be most beneficial to you. First and foremost, you should consider your personal preference as well as your financial situation over the coming years, but it can also be helpful to think about the following:

• Is your credit score strong? The better your score, the more likely you are to qualify for a broader range of options with lower interest rates.
• Are you planning to own the car from the offset, or are you happy to lease the vehicle until the repayment period ends?
• Would you prefer a new or used car? Typically, pre-owned vehicles offer a wider variety of finance options.
• Do you tend to use your car for shorter day-to-day journeys, or are you travelling many miles regularly? Some finance options require you to agree and adhere to a certain number of miles, with penalties incurred if you exceed these limits.

Getting a new car is an exciting experience, and at T W White & Sons, we want to make the process as easy as possible for you. View our range of new cars and used cars, or contact us for more information on the finance options available to you.

This article was created in partnership with DS Burge & Co. If you are interested, you can learn more about the tax implications when purchasing a company car.