How does car finance work? Make your choice with confidence!

Beep beep! That’s the noise cars make, and also the censored version of your thoughts on car financing. It’s one more financial tool that’s needed by so many, yet confusing for all.

Car financing refers to the many ways to buy a car, and here in the UK, we have four main types of car financing. Each has its unique features, benefits, and drawbacks.

Here, we’ll tell you what you need to know about the four most common types of car financing. Additionally, we’ll help you determine which type of financing is best for you, and share tips for getting the best car financing deal.

We’ve a lot to cover, so let’s dive in!

The four main types of car financing

In the UK, there are four main types of car financing. Payments and ownership vary between them, making it vital to understand the distinctions before you make a purchase.

A personal loan is the most direct path to car ownership. When you’re approved for the loan, the bank or building society purchases the car and gives it to you. You then make regular payments including interest to the lender.

Advantages of using a personal loan

• You may be able to negotiate a lower price because the seller will be paid in full upfront.
• You don’t need to make a large payment upfront, but doing so can lower your monthly payment.

Drawbacks of using a personal loan

• If you have a poor credit score, you may face less-than-favourable interest rates. Additionally, your monthly payments could fluctuate as interest rates change.
• The vehicle’s value will depreciate a significant amount by the time you pay the loan off. If you have a common five-year loan term, your vehicle’s value could drop 50% by the time of your final payment.

Related read: What credit score is needed to buy a car in the UK? 

Buying a car with a hire purchase is similar to a personal loan. The main distinction is that the hire purchase provider, be it a car dealership or bank, retains ownership of the car until your final payment.

H4: Advantages of a hire purchase

• Fixed payments are predictable and are easy to account for in your budget.
• You can lower your monthly payment by extending the term length. (If you do this, you’ll pay more in the long run due to interest. However, some may prefer that if it makes their monthly payment easier to budget for.)

Drawbacks of a hire purchase

• Your loan is secured against your car (which is technically still the bank’s car). So, if you miss payments, the bank or HP provider can repossess their vehicle.
• You need to pay an initial deposit. This is usually around 10% of the vehicle’s cost. So, if you’re buying an £18,000 car, you can expect to fork over close to £2,000.

Related read: How long does a missed payment stay on your credit report?

A personal contract purchase is almost identical to a hire purchase, but it has one critical difference: you’re only paying for the vehicle’s depreciation. This means that at the end of the term, the car still isn’t yours. You’ll need to make an additional ‘balloon’ payment to own it outright.

Advantages of a personal contract purchase

• At the end of the agreement, you have the option to return the car or buy it outright.
• Because you’re only paying for the vehicle’s depreciation, you’ll typically see a lower monthly payment than any other type of car financing.

Drawbacks of a personal contract purchase

• Your final balloon payment can be expensive.
• Because you’re paying for the car’s depreciation, you’ll be held responsible for the vehicle's mileage. This makes it a poor choice for car financing if you drive a lot.

Where a car loan is like buying a house, a lease or personal contract hire is like letting a flat. You’re essentially renting the car and you don’t have an option to buy. This is because you’re only paying for the car’s depreciation. But, as with letting a flat, you’re not committed long-term.

Advantages of leasing

• Fees like road tax are often included in leases.
• Lease terms can be short, allowing you to switch cars relatively frequently.

Drawbacks of leasing

• You don’t have the option to buy.
• You’ll be charged for excess mileage just like with a personal contract purchase.

The newest type of car financing on the market — which isn’t really financing — is a subscription. Volvo, Hyundai, Renault, and more manufacturers have introduced car subscription services in recent years. They’re usually billed as an alternative to leasing, although they tend to be quite expensive.

Advantages of car subscriptions

• Maintenance, insurance, road tax, and more are included in several manufacturers’ subscription offerings.
• Subscriptions offer flexibility for those who have changing vehicle needs.

Drawbacks of car subscriptions

• If you need a vehicle long-term — by which we mean more than a couple months — a subscription will quickly become the most expensive way to finance a car. 

• If you want the lowest cost over time, a personal loan is the best choice. However, if you have low or no credit, it will be harder to get.
• If you have poor credit, a hire purchase may be more accessible. This is because the financing is secured against the car. So, if you keep missing monthly payments, the lender can repossess the vehicle.
• If you want the lowest monthly payment, a lease or personal contract purchase may suit you. Keep in mind that neither of these types of car financing are a path to car ownership.

Ultimately, it’s vital to assess your needs and budget to determine the best type of car financing. 

According to AutoTrader, the average price of a used car in the UK is a whopping £17,732 as of August 2023. If you’re making such a significant purchase, you want to know that you’re doing everything you can to get the best deal.

Follow these tips for getting the best car financing.

1. Shore up your credit score

The better your credit score, the better terms you’ll be able to receive if you go for a personal loan. If you qualify for a lower interest rate, it could end up saving you hundreds of pounds over the loan term.

Related read: The beginners guide to building credit the right way

2. Make a larger initial payment if you have the cash

If you’re financing your car with a personal loan or hire purchase, making a larger initial payment can be useful. This can help reduce your monthly payments or shorten the loan term. But don’t make a larger payment upfront if it will make you financially vulnerable.

3. Set up direct debits for monthly payments

Your payment history is one of the most influential factors that forms your credit score. Even missing one payment could damage your credit score. For peace of mind, enrol in direct debits for your car financing so you don’t damage your credit score.

Related read: What affects your credit score in the UK

When financing a car, there are a lot of things to keep in mind: how much you want to pay, what your credit score qualifies for, whether you want to own the car, and more. But a car is a tool, and you need to consider whether it will do the job you need it to.

Before you enter a car financing agreement, consider the following:

• Will you be having children in the near future? You’ll want to ensure that the type of car financing you choose meets your future needs. A lease or personal contract purchase will allow you to switch cars quickly. A personal loan will lead to ownership, so it’s important for that car to meet your future needs.
• What are your insurance costs? Car insurance can be costly. As of 2020, car insurance adds an average of £71 and £53 per month for 20 year olds and 35 year olds respectively. Make sure that your budget accounts for additional expenses like insurance.
• What are your expected maintenance costs? Newer cars are more expensive, but usually less expensive to maintain. Alternatively, used cars tend to be more affordable, but may have greater maintenance needs. Before you enter a car financing agreement, consider what you want from a maintenance standpoint. Otherwise, you could be setting yourself up for frustration.

Pave can help you build your credit for car financing

Regardless of what type of car financing you choose, your credit score will play a role in getting the best deal. If you have a low credit score or have a limited credit history, you might struggle to get a personal loan or see expensive monthly payments.

Building your credit score even a little can have a significant impact on your long-term car financing costs. But doing so can be hard, especially if you don’t know where to start. That’s where Pave comes in. Our app not only gives you personalised credit fixes, but helps you understand the actions that build credit in the long run.

Plus, Pave keeps an eye on your bank account and upcoming bills to help you avoid missing payments and damaging your credit score. If you want to build your credit score before getting car financing, join the hundreds of thousands of Brits who have used Pave. Download Pave from the App Store or Google Play to get started today!