Car finance explained: everything you need to know when buying a car
From personal contract to hire purchase and leasing, we explain the different car finance options to cut the cost of getting behind the wheel
Navigating your way round car finance options isn't easy - from PCP, leasing to hire purchase deals - you may be wondering which one is best and how they work.
Record numbers of drivers got on the road with new cars during 2023 and data from the Society for Motor Manufacturers and Traders showed there were 1.9 million new cars registered in 2023 – a 17.9% annual increase and the best year since the pandemic.
February is often hailed as a good month to pickup a used car bargain as dealerships are quieter ahead of new car registrations in March.
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The average cost of a car is between £12,000 and £17,000, according to NimbleFins so while buying a vehicle with cash can give you more bargaining power, there are more effective ways to spread the cost of a new or used car with a finance deal.
Many dealerships offer 0% finance deals or even relatively low interest rates on new and used vehicles.
This means you can often purchase a more expensive car and pay it off over a set period, while you aren’t hit by depreciation as soon as you spend on a lump sum on a vehicle and drive it from the dealership.
The Financial Conduct Authority has just launched a review into commission charges in the car finance market so it is worth knowing what you are getting into with these types of deals.
Here is what to consider when looking at car finance options.
How does PCP work?
One option is personal contract purchase (PCP).
With this option, you pay a deposit followed by fixed monthly payments over a set period.
The level of payments will depend on how much deposit you pay and the length of the deal. For example, a two-year PCP deal will have higher monthly repayments than a five-year deal but you end up paying more on a longer-term deal.
The payments are generally lower than buying a car upfront as they cover only a portion of the car's value and at the end of the term you either pay a final balloon payment to own the car outright, return it, or use any equity towards a new car.
“This flexibility makes PCP appealing, especially for those who enjoy driving newer models and appreciate the ability to change cars frequently,” says Pete Ridley, Car Finance Saver.
“It’s also good for those who aren’t too bothered about having a ‘legacy’ car i.e. one they’ll have for years on end and might look to pass on to others.”
Buying a car using hire purchase
After paying an initial deposit - usually around 10% of the car's value - you cover the full cost of the car in monthly instalments over a set time.
This can between one and five years but upon completing all payments, the car becomes yours.
“This option is fitting for drivers who prefer the simplicity of a standard loan or intend to keep their car for a longer duration and aren't looking for the latest models,” adds Ridley.
Leasing a car
A third option is leasing, where you effectively rent the car over a set period. Unlike PCP and hire purchase, there is no option to buy the car at the end, you simply give it back.
“One of the primary advantages of leasing a car is that monthly lease payments are typically lower than loan payments for purchasing the same vehicle,” says John Wilmot, chief executive of LeaseLoco.
“This can make leasing an attractive option for individuals who want to drive a newer or more expensive car without the burden of high monthly costs.”
Some companies may even offer employees finance to help buy a car and repay through salary sacrifice. This can reduce your tax bill but there may be a benefit-in-kind (BIK) to pay.
It is a popular way to purchase electric vehicles though as the BIK is currently only 2%, says the Electric Car Guide.
The tax rate is rising to 3% in 2025, 4% in 2026 and 5% in 2027 but in comparison the charge on petrol and diesel cars starts at 15%.
All these types of finance may have annual limits on mileage so check the terms as there could be high fees for going over this. You will also have to keep the car in a good condition with regular servicing and MOTs, plus you could be charged for any damage or if the vehicle is left in a poor condition beyond just wear and tear at the end of the deal.
How to choose the best car finance option
It is worth comparing the interest, terms and types of car you can get across all the different sorts of finance.
You can shop around for finance on websites such as LeaseLoco, CarWow and Car Finance Saver as well as from Auto Trader or direct with a dealership.
The rate you are offered will depend on your income as well as your credit score so it is worth keeping your credit report updated.
Ridley suggest matching your budget to the different schemes.
For example, PCP offers lower monthly payments but will mean a larger final payment if you wish to own the car, while hire purchase spreads the total car cost over the agreement period, typically resulting in higher monthly payments but no final balloon payment.
“Someone on a lower wage might be better off with a PCP arrangement as this will better fit their budget and they aren’t obligated to pay for the car in full at the end if their finances do change,” he says.
“HP arrangements are perfect for those who want to buy their chosen car outright but might have financial commitments that make it easier to pay for the car over a series of months where they can spread the cost.”
It is important to look at the total cost of the deal over the full term rather than just the monthly repayments as well as any administration charges or penalties for exceeding mileage limits.
“Don’t just go for the lowest monthly payment for the sake of it. If you can comfortably afford to pay more, it can work out in your favour if you opt for the higher option,” says Mark Attwell, director of AA Car Finance.
“Make sure you choose a manageable monthly repayment. Buying a car outright with your savings can put a hard ceiling on the make, model and age of car that you end up driving away from the forecourt. Motor finance often removes this ceiling as instead of a one-off lump sum, the cost of the car is split into more manageable monthly repayments.
“However, it’s important to understand how much interest you will pay and that you feel confident you can afford it for the full length of your agreement.”
There will be more costs to running a car than just the finance though.
Jo Robinson, director of lenders at car finance specialist Zuto, says buyers should add in rough estimates for fuel consumption, servicing and maintenance of your car, MOTs, vehicle tax and car insurance, which can quickly add up.
“Typically, you’ll find that cheaper cars and cars with smaller engines will mean cheaper car insurance, especially for new drivers,” she says.
“Different car models will also differ on fuel consumption performance and overall reliability, so be sure to do your research to help understand potential costs beyond your monthly payments.”
“Looking at our most popularly financed cars, many people often opt for makes such as Vauxhall, Ford and Nissan due to their affordability and reliability.”
What determines the cost of a car?
There are lots of factors that determine the price of car.
A big factor is the make and model, so a Porsche would typically be more expensive than a Ford.
It will also depend on if you want a top of the range sports car, family-focused SUV or just a hatchback.
If you are buying a used car, then you should consider the mileage, age and condition.
“The car’s age is one of the most essential valuation factors. A brand-new car’s value drops as soon as it is purchased, and with every year, its value depreciates further, by how much will depend on the model, variant, make, and other supply-demand factors,” says Paul Barker, managing editor at CarWow.
“Mileage is another critical factor – generally speaking, the more miles on the clock, the lesser the car’s value.
“If a car has been well looked after, regularly serviced and properly maintained, it will be worth more than one that hasn’t. A car’s accident history will also be a significant factor – generally people are reluctant to buy a car they know has been in a serious accident, so cars that have been damaged and repaired will be worth a lot less.”
Timing is also important.
Jonathan Such, head of sales at vehicle finance company First Response Finance, says June and December may be the best months to grab a bargain as people are less likely to make a hefty investment ahead of the summer or Christmas holidays and dealers might be more willing to negotiate.
“Visiting dealerships at this time of the year can also make you one of a smaller group of motorists who are ready to make a purchase,” he says/
“So, if you sign the dotted line in June and December, you might be able to cruise away with a better deal.
“What’s more, consider popping by a dealership towards the end of the month. There is a chance that salespeople may have already reached their monthly sales target, meaning they might be more willing to let you drive off at a more budget-friendly price.”
Lucy Sherliker, head of customer at car finance specialists Zuto, says February is often the best month of the year to pick up a second-hand car bargain due to new registration plates being released in March.
"In the weeks leading up to this date, demand at dealerships can be is typically lower than average meaning you could secure a good deal," she says.
"Many people also look to part exchange their car, replacing this with a brand new car, meaning you’ll likely have increased options for a used car."
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Marc Shoffman is an award-winning freelance journalist specialising in business, personal finance and property. His work has appeared in print and online publications ranging from FT Business to The Times, Mail on Sunday and the i newspaper. He also co-presents the In For A Penny financial planning podcast.