The ever-growing car finance market

Buying a new or used car should be an The ever-growing car finance marketexciting and enjoyable process as you pick out a vehicle that will hopefully make your life easier, safer and more fun. The prospect of paying for a new set of wheels might not fill you with so much joy, however, as the range of financing options can seem a touch unsettling at first.

It needn’t be this way though, as the various options can be quickly and easily explained, meaning that you only need to decide which suits your financial circumstances best. With car finance explained, you’ll be on your way to making the right decision in no time.

How does car finance work?

Hire purchase (HP)

Pros: Small initial deposit, manageable monthly payments

Cons: Interest payments (which can be high), no right to sell vehicle until final payment, the finance is secured on the car so if you default on payment, the finance company will reclaim the car

How it works: This is a way to get access to the car you want if you can’t afford to pay for it upfront, or can’t secure a loan. A deposit of around 10% is usually required, followed by a series of fixed monthly payments that include the interest and spread the cost of the purchase.

This option is excellent for buyers on a budget who prefer manageable monthly payments to one larger lump sum. You will end up paying more over time through the interest rate, but HP essentially acts as a low-risk credit agreement secured against the car only, rather than all of your assets, as is the case with a personal loan. But remember that the car is not actually yours until you have made the last payment.

Personal contract purchase (PCP)

Pros: More flexibility than hire purchase, lower monthly payments so good for those on a budget, great for those who have predictable driving patterns

Cons: Possible negative equity of vehicle, significant penalties if you exceed the agreed mileage or if you don’t look after it properly and you never actually own the car. Default on payments and the finance company will reclaim the car

How it works: Much like HP, PCP requires an initial deposit and fixed monthly payments. The difference between these two agreements is what happens at the end of the term. With PCP, your monthly payments are based on the depreciation of the vehicle for the time that you have it and are, therefore, significantly lower than with an HP agreement. At the end of the agreed payment term you will have to choose one of three options:

  1. Return the vehicle to the dealer and walk away
  2. Keep the vehicle by paying the car’s estimated residual value
  3. Start a new agreement on a new car

If you choose to return the vehicle to the dealer, it will incur no extra costs, provided it’s in good condition and you haven’t gone over the agreed mileage limit. It’s essentially as if you’ve made an elongated rental agreement for the vehicle.

If, however, you choose to keep the car, you’ll need to make what’s known as a ‘balloon payment’. This is where you pay the amount previously decided at the start of the agreement as the vehicle’s guaranteed future value (GFV). This amount is determined by many different factors, including the duration and amount of your monthly payments, as well as the projected retail value of the car itself. If you choose this option, the vehicle is yours to own outright.

Finally, you can choose to trade in the vehicle for a different one. In this case, the GFV equity is used as the deposit for the new vehicle and a new agreement is drawn up.

One stand-out issue with PCP is that if the vehicle goes into negative equity – i.e., it depreciates too much in value over the period of monthly repayments – you’ll be expected to make up the difference at the end of the term.

Personal loan/car loan

Pros: Simple path to ownership, straightforward interest charges, puts you in the position of cash buyer giving you a bargaining opportunity

Cons: Potential seizure of assets if loan is defaulted on

How it works: By taking out a loan through a bank or building society, you can quickly and easily get the required funds to buy the vehicle of your choice. It’s also easy to compare loans online and find the best option for you by looking at the annual percentage rate (APR) of the interest charged on the loan.

If you plan to repay the loan early, there could be a penalty for doing so – so make sure that the lender will allow this penalty free. There is another key consideration with personal loans: if you default, then the financial institution could, as a last resort, seize personal assets other than the car. If defaulting seems like a possible outcome, be certain that you’ve read and understood all the clauses your chosen lender offers.

Dealer finance

Pros: Negotiable rates, solid APR deals to be had. Sometimes there are 0% deals to be had but these usually require a large deposit (typically a third of the value of the car)

Cons: Can be more expensive than other options, research needed

How it works: You can make a financing agreement directly with the dealer that you buy from, with all manner of repayment terms and package deals available. It’s vital to bear in mind that an element of research will be needed to guide you towards the best deal. You’ll have to compare rates, added extra benefits (such as free servicing) and any hidden charges.

If you’re happy to do a bit of legwork, however, then there are some excellent deals to be had. Remember, like the vehicle price itself, you’re making a deal, so everything is up for negotiation. If the dealer is keen to make the sale, they may be willing to accommodate you by being flexible with the financing agreement.

Self-finance

Pros: Full ownership, no interest to pay, as a cash buyer you are in a strong bargaining position

Cons: Whole asking price required upfront

How it works: Perhaps the simplest and most direct option is to finance the purchase yourself. By paying the full asking price upfront, you make it a simple purchase transaction, with no interest to pay or extra charges to consider. You just authorise the payment and you’re ready to drive away.

The downside is that self-financing requires you to find the whole asking price yourself, rather than breaking down the total sum into more manageable instalments. If you have the funds ready to hand, however, then self-finance represents the simplest and most direct route to purchase. You need also to consider the loss of interest from savings if that is how you plan to buy your next car. Research for AA Cars shows that, thanks to low interest rates, using savings is actually the most popular way of funding a car purchase.

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