How does car finance work?

Aside from your house, your car is probably the most expensive purchase you’ll ever make. So how are you going to pay for it? Our car financing guide looks at the different options.

Aside from your house, your car is probably the most expensive purchase you’ll ever make. So how are you going to pay for it? Our car financing guide looks at the different options.

Alex Hasty
Insurance and finance expert
7
minute read
Do you know someone who could benefit from this article?
Last Updated 16 FEBRUARY 2022

Pay with cash or savings

If you’ve got cash in an account somewhere, it won’t be earning much interest. It might be more cost effective to use it to buy your car, rather than taking out a loan or finance plan. Even if you don’t have enough to buy the car outright, you could still put down a larger deposit to reduce your monthly instalments.

Did you know?
Due to money laundering and fraud rules, most dealerships won’t accept a wad of cash as payment for car purchases. The sale needs to be traceable, so when we say ‘cash’ we mean payment with a debit card or direct bank transfer. Most dealers won’t accept personal cheques either, as they take longer to clear and can be easily forged.

Join a hire purchase scheme

Finance plans are extremely popular. According to the Finance and Leasing Association, 92% of new private cars bought in 2021 were paid for with some kind of finance scheme

Hire purchase is usually available direct from the car dealership, which makes the process easier. You’ll have to put down a deposit (10% is standard) and the rest will be divided into monthly payments over a fixed term (usually between one and five years).

The advantages here are that the interest rate is usually fixed, which means you’ll know how much to budget for each month. And if you’re buying a new car, you may find you get a better deal compared to buying a used car. The downside is that new cars depreciate more quickly.

One of the main drawbacks of hire purchase is that you can’t modify or sell the car until you’ve paid it off. Also, how much you pay back will depend on your initial deposit and the length of the payment period. A small deposit and short loan time will mean bigger monthly payments. But a longer loan period may well mean that you pay more in interest.

Always look for deals that offer 0% finance. These are especially good if you can pay a big deposit – that way your monthly instalments will be interest-free and the repayment period shorter. You’ll also need to weigh those up against the cost of running a car.

Lease your car

If you want the convenience of not having to deal with warranties, maintenance and services, a personal contract hire (PCH) or car leasing agreement may be a good option. The arrangement is simple - you pay a monthly rental fee, then at the end of the period you give back the car.

A PCH plan usually means paying three months’ rental in advance. Some plans also include a maintenance package, meaning you don’t have to worry about services or even car tax. Your monthly payments will be lower than they would be with a hire-purchase scheme – but that’s because you won’t own the car at the end of the contract.

You’ll also be given the choice of an annual mileage allowance and might find you have to pay an additional amount if you exceed it. If you rack up a lot of miles each year, this may not work for you.

Personal contract purchase (PCP)

Another way of financing a new car is with a personal contract purchase (PCP) agreement. This is a flexible deal with low interest rates and monthly payments, which often gives you the option of buying the car at the end of the rental period. If you do, you’ll be asked to make a bigger final payment at the end, called a ‘balloon’ payment. 

PCPs can be a great way to own a new car for the short term. If money gets tight, you have the security of knowing you can always hand it back. And if you decide not to buy the car, you can part-exchange it for a new one.

Put it on your credit card

A 0% interest on purchases credit card can be a good way to buy your car. Just make sure you pay it off before the end of the interest-free period or move the balance to another 0% card (although this is likely to incur balance transfer fees).

You may also have some protection under Section 75 of the Consumer Credit Act if something goes wrong with the car, although this is not guaranteed.

The downside to credit cards is that some dealerships won’t take them, while others may charge you an admin fee for using a card.

Take out a personal loan

If you have a good credit history, a personal loan is one way to buy your car. The advantage of taking out a personal loan is that you’re able to spread the cost over a long period – sometimes up to seven years. Unlike hire purchase, with a personal loan you’ll own the car as soon as you buy it.

But you’ll need to keep up your monthly repayments. If you don’t, the bank will take whatever has been secured against the loan – most likely the car. 

Compare the annual percentage rates (APR) on personal loans to any finance plans the dealership is offering. The APR is the combined cost of the interest and other charges, which will tell you how good the deal really is.

Use our car finance calculator for guidance on how much you could borrow when taking out a personal loan for car finance.

Insuring your car 

Once you’ve decided how to fund your car, the first thing you’ll need to do is insure it. At Compare the Market, we make that simple. Just tell us a bit about yourself and what you’re buying and we’ll do the rest. 

We’ll search car insurance deals from a variety of providers’ products to find the right one for you.

Frequently asked questions

Can I use finance to buy a used car?

Yes, although if you’re looking for a hire purchase or PCP option, you may need to go to a bigger dealership. The benefit of using a main dealer is that their used vehicles will have been professionally inspected. That said, it’s always wise to check the condition of a used car before you buy. The RAC and the AA both offer used car vehicle inspections.

If you’re buying from a private seller, there’s more chance of haggling yourself a cheaper deal, but your finance options may be limited to a personal loan or paying with a credit card.

Can I get car finance with a bad credit score?

It’s not impossible to get car finance with a bad credit score, but your options may be limited. Car finance companies will want to check your credit history and credit score to see if there’s a risk of you defaulting on your payments. If you have a low credit score or little or no credit history, they may refuse your application. If they do offer you a deal, it will probably be at a much higher interest rate.

Will car finance affect my credit score?

It depends. If you apply for car finance and the lender performs a ‘soft check’ on your financial situation, it won’t show up on your credit file, so shouldn’t affect your credit score. If they perform a more detailed ‘hard check’, it will be marked on your credit file. This won’t necessarily harm your credit score unless you’re refused finance and keep trying your luck elsewhere. Too many applications in a short space of time might give the impression you’re having money troubles, so it could damage your credit score. 

On the other hand, if you take out car finance and make every payment on time without fail, it shows you’re a responsible borrower, which could help improve your credit score.

Before you apply for car finance it’s a good idea to give your credit file a quick once over. Find out how to get a free credit check here.

Can I pay off a finance deal early?

Paying off your car finance early could help you save money on the interest, but you should check the terms and conditions of your contract. The finance company might charge an early penalty fee, which could outweigh any savings you might make.

Will a finance agreement affect my car insurance?

It depends on what type of finance you take out. Your insurance provider will want to know who the legal owner of the car is. If it’s a PCP contract, the legal owner will be the car finance company, and you will be down as the ‘registered keeper’. 

Some insurance providers won’t insure a car paid through PCP, while others may charge a higher premium. However, PCP is becoming more common, so if one provider won’t insure you, there should be plenty of others that will. 

Just make sure it’s clear who the legal owner is. If there’s an incident and you need to make a claim, it could invalidate your policy if you say you’re the owner when you’re not.

Is car financing right for me?

Financing could be an affordable way of getting your hands on a brand new car without paying the full cost upfront. But it largely depends on what you prefer and what you can afford.

For example, a personal loan is better than PCP or leasing options if you want full ownership of your car from the start. It also gives you the option of buying from a private seller.

If you’re dead set on borrowing to pay for your car, we can help you compare car financing options to find out which one works best for you.

Looking for a quote?

Compare quotes with us today and see if you can start saving. 

Get a quote
Compare car insurance Get a quote