The Different Types of Car Finance Explained

Navigating the confusion of car finance packages can be trickier than getting from point A to B when you’re behind the wheel of a car. It’s in the car dealer’s interest that this is the case. In this article we’ll cut through the fog of confusion.

John Ellmore 13 November 2020

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Car finance can be complicated. There are various different types available on the market for people looking to fund the purchase of a car, and if you choose the wrong package you can rack up lots of interest making the car significantly more expensive than if you’d paid in cash.

On the other hand, the right finance for your circumstances can help you make a purchase that fits with your personal financial plans.

Paying up front will be cheaper, but if you don’t have the funds to do this, finance will help you to afford a car.

Read on to find out what each type of car finance is, which might suit your financial circumstances the best, and their pros and cons.

Hire purchase

Hire purchase is a type of car finance which allows you to own a car at the end of your finance plan, after securing the car with a relatively low deposit and monthly payments.

Hire purchase is a secured loan, with the car used as collateral against the amount of the loan. After paying a deposit – usually part of hire purchase car finance plans, but not always – you pay agreed monthly payments.

The structure of hire purchase means that you won’t own the vehicle until the full amount is paid. To own the car outright, you would normally need to pay an “option-to-purchase” fee at the end of the agreement, as well as the final monthly repayment.

If you’re paying a deposit – it will often be a minimum of 10%, although you can pay more if you choose – you will reduce the amount of the loan, and therefore the amount of interest you will pay, and you’ll pay the loan off quicker.

The loan term of a hire purchase agreement is typically from one to five years and varies between providers.

Your credit score will affect the cost of the funding; the better your credit score the better loan terms you’ll be offered.

Hire purchase finance for those with bad credit is available, however the terms are likely to be less in your favour. You’ll most likely be looking at higher interest rates, which can extend the cost of the loan over its full term. You might be better off improving your credit score before applying for finance, so you can secure better terms.

Pros and cons of hire purchase

Pros Cons
  • Flexible loan terms – the shorter the term you opt for, the less you could pay in interest
  • Spread the costs over time as necessary
  • Relatively low deposit
  • Some plans mean you can return the car after paying half the cost
  • Your car could be repossessed if you miss repayments
  • You can’t sell or modify the car until you own it
  • Your deposit and term length affect the total loan cost
  • It can be expensive as a short term option

Conditional sale

Similar to hire purchase, a conditional sale is a method of acquiring a car on finance. You’ll typically pay a deposit backed up by equal monthly repayments over the course of the loan’s term.

Conditional sales can sometimes be confused with hire purchases. The key difference is that with a conditional sale there’s no ‘option to purchase’. You will automatically become the new owner of the vehicle at the end of the loan term, when you make all the repayments.

You can part exchange your existing vehicle to build up your deposit to go towards a conditional sale. You won’t own the car until you’ve paid off the loan amount and the interest. Also, you can’t sell or modify the car unless permission is granted from the leasing company.

Read our guide on selling your car when you have outstanding payments for more information.

There are no mileage charges with a conditional sale, and most hire purchase agreements also don’t have mileage restrictions.

Pros and cons of conditional sale agreements

Pros Cons
  • There’s no ‘option to purchase’ fee
  • You own the car at the end of the agreement
  • No mileage limits
  • Regular monthly repayments
  • Low level deposits
  • You are committed to keeping the car at the end of the contract- you can’t return it or upgrade it
  • Not necessarily cheaper than a personal loan
  • You could lose the car if you can’t make payments
  • You pay insurance costs
  • You can’t sell the car without permission

Personal contract purchase

Personal contract purchase (PCP), is a form of car finance with similarities to hire purchase as individuals will pay a deposit for use of the car and then repay the loan amount in monthly instalments.

However, the difference with PCP is that the borrower doesn’t repay the total cost of the car in equal monthly payments. Instead, they pay lower monthly instalments to cover the depreciation of the vehicle, and can then choose to pay a larger sum at the end of the contract in order to own the car. This sum is called a balloon payment

A PCP plan is usually between 3-5 years. The balloon payment is based on the guaranteed minimum future value (GMFV), which is set by the manufacturer at the beginning of the contract based on what they estimate the car will be worth at the end of the agreement.

All being well the balloon payment will work out at less than the value of the vehicle at that time so that, if the borrower chooses not to transfer ownership of the car themselves, they can return the car and use the difference between the GMFV and the balloon payment to put down a deposit on a new finance plan.

Pros and cons of PCP

Pros Cons
  • Low initial payment
  • Fixed monthly payments
  • You can pass the vehicle back if you chose not to pay the balloon payment
  • You won’t own the car during the contract period
  • You will be charged for excessive damages
  • Charges for going over the agreed mileage

Personal loan

If you don’t have the available cash to buy a car outright, you could take out a personal loan. Providing you have a good credit score and can keep up with the repayments, a personal loan could be a way to finance your car purchase.

With a personal loan you can spread the cost of a car over a certain time period but, unlike car finance options, you will be the legal owner of the vehicle from the start.

Pros and cons of buying a car with a personal loan

Pros Cons
  • Can be used as you wish. You could fund the total or part of the cost of a vehicle
  • With a good credit rating, you can generally get lower interest rates than with finance
  • You own the car as soon as you buy it, so can sell when you want
  • You will be responsible for all repairs
  • Monthly payments can be higher than other forms of finance
  • The funds may take a while to process

Personal leasing

For those that enjoy new cars, personal leasing could be the option for you. Personal leasing car finance allows car hobbyists to drive a new car every few years. This form of car rental is available on new cars and each plan usually runs for between two and four years.

When the lease ends you’ll return the car to the leasing company; there’s no opportunity to own the car, so personal leasing suits those that prefer flexibility. If you only need to drive for a number of years before moving home to a city where you have other transport options, or you want to regularly change cars so you’re always driving the latest model, personal leasing could be suitable.

Personal leasing tends to be cheaper than hire purchase or conditional sale car finance with generally lower monthly payments. But remember, you’re not paying towards owning the car, you’re simply paying a rental fee for the use of the vehicle.

As brand new cars, vehicles rented with personal leasing are usually under the manufacturer’s warranty; this means you won’t have to foot the bill for any expensive repairs.

Many dealerships offer additional car insurance on leased cars to cover you in the event that the vehicle is damaged or stolen. With a gap insurance policy, you won’t have to pay the remaining costs of the contract yourself if the car is stolen or written off.

GAP insurance may be an unnecessary cost if you already have fully comprehensive car insurance cover. However, if the cost of replacement or the cost of the remaining payments are more than your insurer is willing to pay out, you could be left out of pocket if your lease car is stolen or written off.

This is more likely to happen if you have a brand new car that will depreciate quickly. Gap insurance will pay the difference between the amount left to pay on the contract and the current market value of the vehicle.

Car dealerships can be quite pushy when offering gap insurance, but remember it is not a legal requirement, and if you decide you’d prefer to have it, you can potentially take out a cheaper policy elsewhere. So when taking out a gap insurance policy, don’t forget to shop around.

Pros and cons of personal leasing

Pros Cons
  • Get a brand new car
  • Cheaper than other finance methods
  • Mechanical faults are covered under the manufacturer warranty
  • There’s no option to own the car
  • You can’t modify the car
  • Mileage limits

Compare car finance

We offer a comprehensive car finance comparison service. When you’re looking for the best deal to suit your driving needs and financial circumstances you want as much choice as possible to ensure you’re getting favourable terms.

Remember, if you do your own research you will have more choice than taking out finance directly with the dealership and may get a better deal.

Take your time when considering which type of car financing deal is right for you. Make sure that you fully understand the type of car finance you’re taking out, and if you will be able to avoid both the repayments and running costs.

Whilst we have talked to you about how these different types of car finance works, finance providers may have some variations on the products explained in this article. It's important you thoroughly check all the details of any finance agreement you decide to take out

About the author:

John Ellmore is a director of NerdWallet UK and is a company spokesperson for consumer finance issues. John is committed to providing clear, accurate and transparent financial information. Read more

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