Confession time: it didn’t come as a complete shock that not everybody in our recent survey about car finance didn’t understand the ins and outs of how it all works. However, we were surprised at the level of confusion around what is for a lot of people the second-biggest monthly outgoing after rent or mortgage.
For example, 50% of the respondents to our survey who have bought a car on finance weren’t sure how much they owe, while even more (63%) were unaware of their mileage limit or what the penalties are for exceeding it.
The results also suggest there is confusion surrounding what the different types of finance are (49% of respondents didn’t know what PCP meant, for example), which is why we’ve put together this handy reference for anybody who wants to find out more.
Go on then, tell me about car finance
If you’re using any kind of loan to buy or lease your car rather than purchasing it outright then you are using what most people would consider to be a form of car finance. On a wider scale that might be a bank loan or even a credit card, but generally speaking when most people talk about car finance they are referring to one of these three schemes:
- Personal Contract Purchase (PCP)
- Hire Purchase (HP)
- Personal Contract Hire (PCH)
By far the most popular of these is the PCP. Indeed, along with the surging popularity of SUVs (don’t worry, that’s a type of car, not another finance product to worry about) the growth of PCPs has been credited with driving the new car market in the UK out of the 2008 recession and into what would go on to be record levels of growth. Let’s take a look at how it works.
No, it’s not a throat sweet
Sorry to whoever the 2% of respondents were that identified a PCP as a type of throat sweet, because what it actually stands for is Personal Contract Purchase. The word ‘Purchase’ is important here (and not ‘plan’ as it’s often called) because one of the key principles of a PCP is that you have the option of buying the car at the end of the agreement, differentiating it from a PCH (that’s Personal Contract Hire, more of which below) where you are strictly leasing the vehicle but can’t ever own it.
PCPs have become so popular because they structure the loan in a way that only pays off some of the car’s value (generally equivalent to the amount of depreciation it’s expected to suffer), which in turn keeps monthly payments low.
At the start of the agreement there’s a deposit to pay, although this is often subsidised by the car dealer as an incentive to sign up. Then for a set term (usually between two and four years) you pay a fixed monthly amount that includes interest and permits you to drive the car up to a certain mileage limit.
When you reach the end of the your monthly payments you’ll be presented with three options. First, you can hand the car back with nothing else to pay, assuming you haven’t exceeded the mileage limit and there’s no damage to the car.
Second, you can pay a one-off ‘balloon payment’ to buy the car outright. The dealer will outline what this figure at the start of the agreement.
Third, you start another PCP, using any equity in your older car to put towards its deposit.
Whoa there! What’s this equity thing you’re talking about?
This is where PCPs becoming more interesting to both customers and car dealers. Basically, at the beginning of the agreement the dealer will outline a Guaranteed Future Value (GFV) for your car, which is what they guarantee it’ll be worth at the end of the loan period. If it turns out to be worth less than the GFV that’s their problem, not yours.
However, if it actually turns out to be worth slightly more than the GFV the dealer will give you this extra amount in the form of equity, but only if you use that money towards another PCP on a new car. It is through this mechanism that PCPs allow people to switch cars every two or three years without necessarily having to find a fresh deposit each time.
Just remember that being offered equity at the end of a PCP is at the dealer’s discretion, so don’t ever rely on it. For that reason some people also like to save £100 on top of their monthly payments for another deposit if and when it’s needed.
What about Hire Purchase?
If the PCP is the trendy face of car finance, think of hire purchase (HP) as it’s more traditional alternative. Essentially what you’re doing here is paying off the full value of a car over a prolonged period of time (up to five years), rather than saving up and buying it upfront.
As such there are no mileage limits to adhere to and come the end of the loan it’s up to you whether to hold on to the car or sell it and start again (although a hire purchase doesn’t make sense if you’re planning to do the latter), subject to paying an agreed transfer figure whereby ownership is moved into your name.
You’ll generally need to stump up a bigger deposit than with a PCP or PCH, and monthly payments will also be more expensive. However, at the end of it you will have ownership of the car so if that’s important to you a hire purchase is often the best value option.
Got it. So that just leaves Personal Contract Hire, yes?
Correct. As mentioned before, Personal Contract Hire (PCH) is like a PCP but without the option to purchase. Or, put another way, it’s a lease over two or three years in which you need to stick to a mileage limit and return the car undamaged if you don’t want to face any extra charges.
As with HP and PCP there’s an initial deposit to pay and then a series of monthly payments with interest added that cover the car’s depreciation. At the end you give the car back and start all over again, including finding a new deposit. It might not be as trendy or as flexible as a PCP, but prices can be very competitive.
A useful checklist
So that’s the basics of car finance, and the three different deals you’ll tend to encounter. To be sure you know what you’re signing up to, we’ve compiled a handy checklist of questions to ask your dealer. This is all basic stuff, so if they can’t or won’t give a straight answer you are right to be wary.
- Is this a PCP, hire purchase or personal contract hire deal?
- How much is the deposit?
- Is there a dealer deposit contribution?
- What are my monthly payments, including interest?
- What is the rate of interest?
- How long does the contract last?
- What is the total amount payable?
- What is the mileage limit?
- What is the charge if I go over this mileage limit? (This is known as the ‘excess mileage charge’).
- If it’s a PCP, what is the balloon payment at the end of the term?
- Is a servicing plan included? If so, what is the monthly cost if it is removed?
- Are there are hidden fees such as admin fees?
- What happens if I change my mind?
- Are you FCA (Financial Conduct Authority) regulated? If the answer is ‘no’ then walk away.
The Bottom Line
There’s no doubt that the proliferation of car finance deals has not only made owning a new car much easier, but has also allowed people to drive cars that they wouldn’t normally be able to afford to buy outright.
Even so, here at CarGurus our advice remains to always buy from a dealer you can trust (that’s where our dealer ratings are key), and to never borrow more money than you can afford to pay back. This includes being aware not only of monthly payments but also interest rates, deposits and balloon payments if applicable. Running through the above checklist with several dealers to see what each will offer, and getting quotes in writing to compare away from the temptation of the forecourt is a good way to do this.
For more information and the pros and cons of using a bank loan or credit card to finance your next car, read the CarGurus guide: Car Finance Explained
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