All you need to know about car finance

Understanding the different types of car finance available is essential. Additionally, knowing what you can realistically afford and what you plan to do with the car once paid can help you make the right decision. Your credit history will likely affect the financing deals offered, although getting car finance with poor credit is possible. We explain all of this below, but first, what is car finance, and how does it work?

• What is car finance?
• How does financing a car work?
• What are the different types of car finance?
• Can I get car finance with poor credit?

What is car finance?

Quite simply, car finance is getting a car on credit. It is a general term that is used to cover the borrowing options that allow you to get a vehicle instead of making a full upfront payment for the purchase of a car.

How does financing a car work?

Financing a car works by taking the total price of the vehicle and breaking it up into smaller, more manageable monthly payments paid over time. Whatever type of car finance you choose, you have to borrow from a lender. You will likely need to provide a deposit. As part of the application process, a lender will perform a variety of checks, such as affordability checks to make sure you can cover the monthly costs and credit checks.

If approved, you will need to make monthly payments (or instalments), which include interest charges on the amount borrowed for the agreed period (or term). There may be additional fees. In most cases, the money borrowed is secured against the car, which means your car can be repossessed if monthly payments fail. And depending on the type of car finance you choose, you might not own the vehicle outright.

What are the different types of car finance?

Popular car finance options in the UK include hire purchase (HP), personal contract purchase (PCP), and car loans.

Hire purchase

Normally you'll need a deposit (usually around 10%), and you will have to make monthly repayments to "hire" the car. A high deposit will typically mean you get better terms. You can also choose the length of the repayment period (generally up to five years), but if you decide to end the agreement early, you may need to pay an additional fee.

The car is only yours when you've paid the car's entire value, including paying the Option to Purchase fee (about £100-£200). Until then, you cannot sell the car, and if you fail to pay the instalments on time, your lender can repossess your vehicle. A dealership may offer hire purchase agreements on both used and new cars.

This option is convenient if you don't plan to change cars often, as once the car is paid in full, the vehicle is yours. HPs are also an option, even if you don't have a perfect credit score. However, if you don't make your repayments on time, you can lose the car.

Personal contract purchase (PCP)

As with hire purchases, you don't own the car outright, but you will still need to provide a deposit and make monthly payments to the lender. Bear in mind that failing to make the monthly payments on time can mean you lose the car.

The monthly payments cover the cost of depreciation (value of the car going down over time) plus interest. It does not cover the total price of the vehicle. It's good to read and understand the terms, as some PCP loan agreements have additional charges for exceeding annual mileage limits. These fees can be charged on a per mile basis. Damage to the car will also result in further penalty charges.

At the end of the term, you can decide to:

1. Buy the car by paying the leftover balance (called 'balloon payment'), and the vehicle becomes yours.

2. Trade in the car and start a new PCP contract (this usually means sticking with the same dealer).

3. Return the car without paying anything further as long as you have stuck to the terms. For example, the vehicle is not damaged and has been well maintained.

This option is convenient if you plan to change cars regularly. PCP monthly payments usually are lower than HP payments. However, a larger payment will be made at the end of a PCP term if you decide to keep the car. Also, due to the potential penalties (such as going over mileage limits) and the fact you do not own the vehicle, PCPs are not without risks.

Car loans

Car loans work similarly to personal loans; you decide the amount you need to borrow and the time to pay back what you borrow. A good credit score means you are more likely to be offered car loans with low interest. The money is paid to your account so you can buy the car.

One of the most important things to consider when applying for a car loan, is whether it is secured or unsecured. Securing your loan against your car may increase your chances of being approved, and you'll likely get a better rate as there is less risk to the lender. However, if you fail to repay your car loan on time, your lender may repossess the car as a form of payment.

Not paying monthly instalments on time while your loan is secured or unsecured will adversely affect your credit score, reducing your chances of being approved for credit. Car loans are widely available from specialist car loan lenders to banks with car loans. Larger high street banks with car loans include Barclays, Halifax, Lloyds, and HSBC.

DID YOU KNOW: The latest figures released by the Finance & Leasing Association (FLA) show an increase of 47% in car finance volumes for new cars in January 2022 compared to January 2021. A similar trend applies to used cars, with a rise of 41% in car finances taken for the same period.

Can I get car finance with poor credit?

Although lenders will look at your credit history, that does not mean you have to have a perfect score to be approved for car finance. It will likely mean that you might not have access to the best rates for car loans and limited options. There are a few things you can do if you don't have a great credit score and want to improve your chances of being approved: 

• You could try to leave a larger deposit. This will reduce the amount you have to borrow, which will mean less risk to the lender, increasing your chance for approval.
• You could opt for a cheaper car. Again, this means you can borrow less while reducing the risk of lending.
• It may be easier to apply for a Personal Contract Purchase or a Hire Purchase instead of a car loan. If you go for a car loan and have poor credit, it is very likely it will have to be secured to reduce the risk to the lender.
• Another option is to wait and improve your credit score. Check your credit report regularly for any discrepancies and follow progress.

If you have a good credit score, try not to jump to the first option offered to you and shop around for the lowest rate. A word of caution, though, when you compare car finance deals, make sure if a credit check is made, it is a "soft credit search" and not a "hard credit search". Only once you have decided you want to proceed with an application should a hard search be carried out.

Hard searches are visible on your credit file, whereas soft searches are only visible to you. Too many hard searches on your file within a short time can affect your score. It can be viewed negatively by lenders as a sign that you are struggling financially and desperate for money.

TIP: When researching lenders and credit options, make sure only soft searches are performed on your credit file. Hard searches will show on your file and will be visible to other lenders. Too many hard searches in a short period can be viewed negatively.

In conclusion

Car financing is a form of credit. You will likely need to provide a deposit, and there will be monthly instalments that include interest to pay. Failing to pay these instalments can result in your car being repossessed, so it's essential to be realistic in what you can afford to pay monthly and not overstretch your budget. You can still be considered for car financing even if your credit score is not perfect, but you may need to opt for a cheaper car or offer a bigger deposit.

Car loans work similarly to personal loans, and you will own the car. In the case of hire purchases and personal contract purchases, you do not own the vehicle, although you will have that option further down the line. With that in mind, it's worth deciding before you apply for any car finance what you want to do with your car in the future.