What is Car Finance & How Does It Work?

Car finance is a way of funding your next new or used car. It’s a top-level term and covers a few main types of finance, including Personal Contract Purchase (PCP), Hire Purchase (HP) and Personal Contract Hire (PCH).

It gets you behind the wheel of your desired vehicle without paying the full cost upfront. Even if you can afford to buy a car outright, car finance allows you to spread the cost from anywhere between two to five years with added interest.

The type of car finance you choose depends on your needs. We’ve compiled this comprehensive guide to explain car finance and answer all your questions, including ‘what is car finance’ and ‘how does car finance work?’ Explore below to find out more!

Jump to:

• Car finance funds your chosen vehicle, spreading the cost over a set period
• Choose from PCP, HP & PCH
• Available on both new and used cars
• All types include an initial payment and monthly costs with interest
• PCP includes an optional balloon payment at the end
• HP includes a nominal option-to-purchase fee at the end

Car finance is a general term which encompasses three main options: 

• PCP
• HP
• PCH

PCH is in fact a lease but we’ll explain more below.

The finance provider pays for the car and you pay the finance provider back over your agreed term.

You pay for the car with added interest. Customise your car finance to suit your needs by changing the initial payment, term duration and more. All changes affect your monthly payments.

Your lender buys the car and you pay them back over your duration.

There’s an initial payment which can be adjusted, but it’s usually anywhere from 10-20% of the car’s value.

Next, you pay monthly instalments for the duration of your agreement with added interest.

Pay any final fees and the vehicle is yours, or hand it back and start a new finance deal.

Car finance is easy to get as long as you have a decent credit score. Most car dealerships have their own panel of lenders and are able to handle it for you.

This depends on the type of car finance you choose as they all work slightly differently. But essentially car finance takes the value of your chosen car and spreads it across a two-five year period with interest added.

With PCP you’re actually paying for the loss in value over the duration of your agreement, with an optional balloon payment at the end to cover this.

With HP you pay for the full value of the car, so you own it as soon as you make the final payment (and pay a nominal option-to-own fee.)

PCH is a lease so you’re just hiring the car and will never own it. 

Car finance is a type of loan.

HP is a secured loan that pays for the vehicle and spreads the cost over your agreement.

PCP is also a secured loan with your payments covering the car’s depreciation.

There are three main ways to finance a car so it depends on what you’re after. Explore the different car finance options below, including PCP, HP and PCH.

PCP is a popular type of car finance that offers low monthly payments and an optional balloon payment at the end.

Instead of paying for the full value of the car during the agreement, you’re paying for the depreciation of the vehicle. This is how PCP keeps monthly payments lower.

PCP is calculated by taking away the Guaranteed Future Minimum Value (GFMV) of the vehicle (based on your initial deposit, agreement duration and mileage allowance) from the car’s original price.

Your monthly payments cover this difference with interest added. Then at the end, you can:

1. Pay the optional balloon payment and keep the car
2. Hand it back and end the deal
3. Part exchange for another deal

PCP monthly payments are lower because you’re paying for the depreciation in value and there’s a large optional balloon at the end of the agreement.

Bear in mind that if you breach your annual mileage allowance you will be charged per mile exceeded.

The balloon payment is specific to PCP. It basically defers a large chunk of the payment towards the end of the agreement which helps to keep monthly payments lower.

If you want to own the car, you just have to pay this amount.

If you want to end the deal, don’t pay and hand the car back.

You can also trade the car in and put that money towards your next PCP deal.

HP car finance is Hire Purchase, a type of car finance that’s better suited to those looking to own a car.

This is another popular type of car finance that sees you paying for the full value of the car with interest added.

You’re paying for the full price of the car with added interest.

First, you put down an initial payment. Usually around 10% of the car’s value.

Then you pay monthly over three to five years to cover the remaining cost of your vehicle. This includes interest.

There’s a final option to own fee at the end, usually around £100-£200.

PCH stands for Personal Contract Hire and is a lease. Whilst it’s technically not ‘car finance’ it’s still captured under the term. This is because you’re paying monthly for a car and have to put down an initial payment.

The biggest difference with PCH is that you never own the car. Instead, you’re leasing it and will have to give it back at the end of your term.

PCH may be the most simple type of car finance. You choose your car, then select the duration of your agreement, initial payment and annual mileage.

All of these factors influence your monthly payments which are locked in for the duration of your car lease deal.

In the end, you hand the car back and start your next PCH agreement.

APR stands for Annual Percentage Rate. This is the interest rate added to the total cost of your finance.

The higher your APR, the more you’ll pay on top of the cost of the car.
How is car finance interest calculated?
Car finance interest rates are calculated by adding the cost of your car with the APR percentage.

This figure is then divided by the number of months in your agreement.

So if the car costs £20,000 with an interest rate of 12%, you’ll end up paying £22,400 back.

You may find some car finance offers with 0% APR. This means that you don’t pay any interest across the duration of your finance agreement.

0% car finance isn’t its own product, instead, you may find it available on certain PCP or HP deals.

Whilst this means you’re paying less in the long run, there are a few points to consider.

The loan term itself might not be flexible so you might not be able to spread payments out over a longer duration
You may have to put down a larger initial payment to cover more of the cost
You may only be able to find limited PCP and HP options.

For more information explore our guide on 0% car finance

It depends on the type of car finance you choose.

PCP: you own the vehicle if you pay the optional balloon payment

HP: you own the vehicle once you’ve paid the nominal option to purchase fee

PCH: you never own the vehicle.

The finance provider is the legal owner in all types of car finance until you’ve made the final payment.

You’re the registered keeper but the finance provider owns the car until the finance is fully settled.

No, you can’t sell your car if it’s on finance. The finance provider is the legal owner of the car until you’ve paid the finance off in full.

So until then, you cannot legally sell the car.

First of all, you have to be at least 18 years old to apply for car finance. Whilst you can legally drive from 17, you can’t enter into a finance agreement until you’re 18,

Next, you have to pass a credit check. This assesses your credit history and may affect your APR. This is a hard credit check so keep this in mind.

There is no minimum credit score for car finance in the UK. But your credit score will have a direct effect on which types of car finance you can apply for as well as interest rates and other conditions.

Higher credit scores usually mean better deals.

The finance provider will carry out both a hard and soft credit check to get a full view of your credit history.

You only need to supply a few personal details when applying for most types of car finance. This includes:

• Personal details, including name, age & address
• Photo ID, either a driving license or passport
• Proof of income, either a bank statement or pay slip
• Full address history over the last three years

Although this can vary depending on the type of car finance you’re applying for.

Your car finance is usually approved in one to two business days. It’s not instant because the following needs to be sent and approved by the lender:

• Copies of your personal documents
• Signed vehicle contract
• Signed finance contract

You are responsible for getting repairs during your finance agreement. You can choose to either go through your insurance provider or fund the repairs yourself.

PCP and PCH deals may require you to use certain approved garages for any repairs or other work. They may even require you to use a main dealer.

You can spread the cost of servicing as part of your monthly payments with most PCH deals, but you still have to pay for repairs.

You also need to keep your car in good condition to ensure you’re not hit with any fees at the end of your agreement.

It depends on the level of damage. Fair wear and tear is accepted in most car finance agreements. This includes light scratches on the paint, very small chips on windows and minor dents. These don’t have to be remedied.

Larger damage incurs a fee so it’s in your best interest to get this sorted out before handing the car back. This includes large dents, deep scratches, missing trim, torn seats etc.

If your car is written off (or stolen), your insurance provider will pay the current value of your car. This usually isn’t enough to cover the outstanding finance amount as you’re paying interest on top of the car’s value.

Yes, you can pay off your finance early. Here’s how it works for the three main types of finance.

Contact your finance provider and ask for a settlement figure. This is the remaining amount of finance left on your car, including fees and interest, that you’ll have to pay to end your PCP deal.

You have two choices once you have your settlement figure.

1. Pay the settlement figure and keep the car. This is the best option if the settlement figure is lower than the remaining monthly payments.
2. Pay the settlement figure and sell the car*. This option is best if you require cash for your next car.

*You can only sell the car once you've paid the settlement figure.

You can pay off HP early but it comes with a charge. You pay the outstanding capital on the amount your borrowed minus interest, plus whichever below option is the lowest:

• 1% of the remaining amount (e.g. £90 if you have £9,000 left)
• 0.5% of the remaining amount if there are under 12 months left ( e.g. £45 if you have £9,000 left)
• The total remaining interest

You don’t pay extra fees if the amount you pay back early is less than £8,000.

Most PCH contracts require the full amount of the remaining payments to end the lease early. Therefore you should carefully consider if this is the right action as it can be costly.

You can return your car early and end your contract with PCP or HP if you’ve paid off 50% of the finance. This includes interest and balloon payments.

With PCP, this won't be the halfway point of your loan term as you still have the balloon payment which can be up to a third of the car’s valu