Car finance explained: a simple guide to paying for your new car

Cash is king, so they say, but in the world of car finance, the king is dead. More drivers than ever are looking to the ‘monthlies’ instead, reflecting how we pay for many big-ticket items. A remarkable 93 per cent of new cars – and a growing proportion of used cars – are now paid for in monthly instalments. Today there are several schemes, each with their pros and cons, and all of them work in different ways.

Cash prices no longer reflect what most drivers pay, because four £30,000 models could have four completely different monthly repayments, depending on the type of finance, deposit amount, contract length, mileage allowance and interest rate. Cars’ predicted second-hand values affect PCP finance instalments, too.

What should you do at the end of a PCP car finance deal?

So, which type of finance do you go for? Firstly, consider if you want to own the car. With Hire Purchase, it’s yours with the final instalment, while a Personal Contract Plan (PCP) enables you to buy the car or hand it back. However, with leasing – or Personal Contract Hire (PCH) – you must return it.

Next, consider whether you’d rather have the lowest possible monthly payments – plus a large optional final fee to purchase the car – or higher monthly costs with no huge end-of-contract sum. For reduced monthlies, plus the option to buy the car, PCP is better. For a higher monthly rate in exchange for owning the car without a large final bill, Hire Purchase is likely the better option.

Be aware that you’ll pay more interest with PCP than Hire Purchase (assuming the same deposit, contract length and interest rate), because the lower monthly payments of a PCP mean you’re paying off the balance more slowly. Finally, for low monthly payments with no chance to own the car, consider PCH leasing – and if you do, it’s worth comparing PCP and lease costs, because both schemes let you run the car for a few years and then return it.

While PCP and Hire Purchase are classed as finance – so consumer protection rights enable you to return the car early, without additional charges in some instances – leasing is effectively a rental product, so this doesn’t apply. If you need to return a lease car early, you’ll have to negotiate with the leasing company and you could still be liable for remaining payments.

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To determine the best deals, you’ll need to get like-for-like quotes, with the same deposit, contract length and – with PCP and leasing – a mileage allowance. That’s because monthly payments are dramatically affected
by the deposit, contract length and mileage allowance. The larger, longer or lower these are, respectively, the less your monthly payments are likely to be.

The same car could vary from £100 per month to £400 per month simply by varying the contract terms,
so don’t be seduced by manufacturer deals with low monthly payments enabled by enormous deposits, tiny mileage allowances or extremely long contract terms hidden in the small print. Monthly payments with typical contract terms will be far higher.

New-car finance is often subsidised by manufacturers, meaning relatively low APRs (which reflect interest and other compulsory charges) and potential ‘deposit contribution’ discounts, although the amount financed is high. Meanwhile, used-car finance typically involves borrowing less money, but comparatively high interest rates. Consequently, if you’re considering new and used cars, it’s important to have like-for-like quotes to directly compare costs.

Typically, new cars have better-value finance than very recent used cars, although older second-hand cars can cost dramatically less per month than new equivalents.

What is Personal Contract Purchase (PCP) finance?

Personal Contract Purchase is one of the most popular types of car finance, because it offers low monthly payments compared with a car’s value, and the option to buy at the end of the contract or return the car to the finance company.

PCP consists of a deposit (although this can be nothing, in some deals), followed by a series of monthly payments. At the end of the contract, you have a choice: make the large optional final ‘balloon’ payment – or Guaranteed Minimum Future Value (GMFV) – to buy the car, or simply hand it back with nothing more to pay. That’s provided you’ve stuck to the pre-agreed mileage limit and there’s no damage beyond fair wear and tear.

Go over the mileage limit and return the car, and you can expect to be issued with a per-mile fee. It’s the same story with damage; you’ll be charged for significant dents, scratches or interior stains and tears. But if you make the optional final payment, and purchase the car, none of this is an issue.

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PCP works if you want low monthly payments but aren’t necessarily concerned about owning the car. You can choose to make the optional final payment to buy it; however, this is often half of the car’s value at the start of the contract. That means that you’d need to find £10,000 or more for even a mid-range Ford Fiesta at the end of a three-year contract; an amount most people simply don’t have to hand.

You can refinance this amount, but do that and you end up paying interest on the balance twice. As a result, Hire Purchase (HP) is a wiser choice if you want to own the car, because you’ll end up paying less interest with a HP deal of the same length.

What is Personal Contract Hire (PCH) leasing?

Car leasing – also known as Personal Contract Hire or PCH – works like long-term car hire. You make an up-front payment – often referred to as the ‘initial rental’ – followed by a series of monthly rentals. Get to the end of the contract and then you simply hand the car back, with no option to buy it, unlike with PCP finance.

However, monthly lease payments can be lower than with an equivalent PCP set-up, so if you’re sure you don’t want to own the car, it may be worth comparing leasing and PCP finance deals to see which offers you better value. If being able to own the car is important to you, choose PCP finance or Hire Purchase. All leases include mileage limits and damage charges, because the car must be handed back at the end of the term.

Given that you’re not borrowing money – rather you’re renting a product – car leasing doesn’t include the same consumer protection as finance offerings like PCP and Hire Purchase. So, if you’re concerned that you may want to end the contract early, you’ll have more ability to do that with PCP or Hire Purchase. With a lease, you are more tied in and may not be able to end the contract early, even if you hand the car back.

What is Hire Purchase?

Hire Purchase works like a traditional car loan; you pay a deposit – which can be as little as zero – then a series of monthly payments. Once you’ve made the last instalment, the car is yours.

Hire Purchase works for those who want to own the car and are happy to pay a little more each month to avoid a large end-of-contract payment as seen with PCP finance. Another benefit of the larger monthly payments is that there’s less interest to pay (assuming the same deposit and contract length), because you’re paying off the finance balance quicker than with PCP.

Used car finance explained: PCP, PCH, leasing, loans and top tips

Hire Purchase is geared towards ownership at the end of the contract, but you can hand the car back early if, for instance, your financial situation changes and you’re no longer able to afford it. This is an option with PCP finance, too, but you can only use it once you’ve paid half of the total amount – which happens around halfway through a Hire Purchase contract, but potentially only towards the end of a PCP deal.

Other car finance options

Credit card

Low-interest or even interest-free borrowing may be available for a set period of time with a credit card, but you have to make sure you know exactly how long it lasts and how much interest is charged after this, because rates can rocket. You’ll also need to be sure that you can access a high-enough credit limit to cover the cost of the car and that the seller accepts credit cards before paying this way.

Extended mortgage

Mortgages can offer low interest rates compared with many car finance offers – and freeing up cash for a car by increasing your mortgage borrowing can result in only small monthly payment increases. However, mortgages typically last for much longer than car finance contracts, so you still may end up paying a high amount of interest. If you’re considering this option, it’s worth totting up the total cost of additional borrowing compared with other car finance options.

Equity release

This is another way for homeowners, typically those over 55 years old, to borrow against the value of a house. It’s a contract that is settled when you die, with lenders giving you cash in exchange for taking a share in the house, which they get back – with interest – when you die. This may seem attractive, because you won’t be around to make payment, but interest rates are very high compared with standard mortgage rates and costs can spiral if you don’t make any repayments in your lifetime. As a result, your beneficiaries may receive very little – if anything – due to the high interest rates charged, potentially long borrowing period and the option not to make repayments.

Click the links below or on the top left of this page to get full guides on each of the key car finance options…

How to pay for your new car

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Car finance deals: top tips

Five key points to remember when choosing a car finance deal...

1. Shop around Compare the different types of car finance deals that are available. Look at the APR (Annual Percentage Rate) interest rates and the total cost of borrowing associated with each deal to identify the one that suits you.

2. Don't stretch your finances Only sign up to what you can afford. Don't over-extend yourself to get that better model and make sure you can afford the monthly repayments. Remember that if you pay a bigger deposit then the monthly bills will be smaller and the overall costs will be kept down. If you are struggling with repayments, then Citizens Advice will be able to offer information about what you can do.

How to get the best deal when buying a new car

3. PPI and GAP insurance can be costly Your financier will offer insurance to cover the repayments if something goes wrong - this is called Payment Protection Insurance, but think carefully before taking it out. PPI may help if you're unable to keep up repayments and GAP insurance will pay out if the car is written-off in an accident while there's still finance to be paid on it. Both are expensive, however, and the terms and conditions of the cover can limit their usefulness. On some loans, PPI was added to the amount borrowed and the borrower would have to pay it off over the term of the loan. This type of PPI policy was banned in 2009.

4. Be aware of additional charges Check the small print and pay particular attention to additional charges that you might incur if you decide to pay the loan off early, or if you exceed the mileage limit (the latter is usually a pence per mile penalty).

5. Keep your credit score up to date Your personal credit score will go some way to determining the extent of the finance packages you can get. Requesting a copy of your credit statement and checking it for mistakes is the first step in improving your score. Repaying your loans in advance or above what is required also boosts your credit rating. Avoid taking on too many loans at once, as this comes across to lenders that you have too many financial commitments and means you may not be able to stretch to any more, making you a credit risk.

Car finance jargon buster

APR: The Annual Percentage Rate, or the amount of interest and any other charges for borrowing money.
Deposit: The up-front payment on a PCP finance or Hire Purchase contract. This can be as little as zero.
Deposit contribution: A discount on the finance provided by the manufacturer or finance company.
Excess mileage charge: A per-mile fee charged for exceeding any pre-agreed mileage cap.
Fair wear and tear: The amount of damage accepted as a normal sign of everyday use when returning a car at the end of a lease or PCP finance contract. This is commensurate with the age and mileage of the car; a greater amount of wear is accepted on older and higher-mileage cars.
Initial rental: The up-front payment required with a lease. Typically presented as a multiple of monthly rentals.
Interest rate: The amount charged for borrowing money, expressed as a percentage.
Mileage allowance: The pre-agreed mileage cap on a lease or PCP finance deal. This is only applied with PCP where a driver chooses to return the car at the end of the contract.
Monthly payment: The amount charged every month with a PCP finance or Hire Purchase contract.
Monthly rental: The amount charged every month with a PCH lease.
Optional final payment: The amount you must pay – or refinance – at the end of a PCP finance contract to take ownership of the car.
Total amount payable: The overall cost paid on a PCP finance or Hire Purchase contract – including deposit, monthly payments, the optional final payment (in the case of PCP) and any other compulsory charges.