How Do Car Loans Work? A Complete Guide

Of course, like many financial topics, car financing can be a little confusing. Especially if you’re buying your first car or have never taken out a loan before. The good news is, we’re here to help with a complete ‘how do car loans work’ guide.

Read on for everything you need to know about auto loans in the UK, including the main benefits of car financing, an intro to industry lingo, some interesting statistics and more.

How does financing a car work?

When you look past all the paperwork, auto loans are pretty straightforward. Here’s a simple step-by-step to how car loans work:

1. First, you choose the amount you would like to borrow. This number can be calculated by subtracting your cash deposit from the value of the car you would like to purchase. Your car loan will make up the difference and allow you to purchase your chosen vehicle.
2. Next, you’ll choose the length of your loan term. This determines how long you’ll have to repay the loan. Payments are usually made monthly. A car loan quote calculator can give you a better idea of costs without harming your credit score.
3. When your loan is approved, the lender will transfer money directly to the approved car dealer you are buying your car from.
4. After the purchase has been made, you’ll start to pay back loan instalments to your lender, usually on a monthly basis.

The key benefits of car loans

Why do so many Brits choose to take advantage of car loans? Here’s a brief look at the key benefits of auto finance:

Increase your buying power

How do car loans work? They give you the freedom to increase your budget and purchase your preferred vehicle, without having to pay outright.

Get behind the wheel sooner

Finance deals boost your budget in a matter of days, allowing you to get behind the wheel sooner instead of spending months or years saving.

Better budgeting

Making fixed monthly payments means you know exactly what you’re paying for the duration of your finance package. There’s also no need to save up massive amounts to buy a car outright or make a large down payment.

Enjoying a new car

Budget is one of the main factors when choosing between a new or used car. Car prices can be high when buying outright. By financing a car, you can afford a new car without saving up for years or borrowing money from friends and family. With PCP and leasing, you can also change cars at the end of the deal, ensuring that your next car has all the latest features.

Car finance lingo explained

Financing a car doesn’t have to make your head spin. Wrap your head around auto finance with this quick guide to car loan terms:

Agreement term – the total length of your loan.

APR – short for annual percentage rate. This is the additional amount you’ll pay back, on top of the loan. A good auto loan lender should offer APR rates from 6.9%.

PCP – short for personal contract purchase. These types of loans include monthly payments, as well as a balloon payment at the end of the loan if you’d like to own the car outright.

Total repayable – the final balance owed, including the loan itself as well as interest, fees, and other payments.

Credit score – this is a numerical indication of your risk for finance providers. A good credit score means you’re low risk, while a poor credit score indicates a higher risk to lenders.

Interest rate – this is the amount of interest you’ll pay on top of the loan amount.

Down payment – a down payment is an up-front payment for a financed car. It’s paid at the start of the deal, like a deposit, to reduce the overall loan amount. This reduces your monthly instalments going forward.

Balloon payment – the optional final payment on a PCP deal. You have the choice to make this payment to own the car outright or return the car.

Average car loan monthly payments

We know that around two million cars are purchased on finance every year but what about monthly repayments? Studies suggest the average British motorist puts £194.80 per month towards car finance payments. After rent and mortgage payments, 65% of motorists say their car is the biggest outgoing expense in their life. Interestingly, men spend a little more with payments averaging £215.70. Women are a little thriftier and spend £173.30.

What about insurance?

You’ll still need to purchase insurance when you take out an auto loan, so don’t forget to factor this into your budget. Expect to pay around £53.40 a month for car insurance. Again, men tend to have higher premiums and pay around £64 per month while women average just under £42.

4 car finance options

How does financing a car work in terms of the different car finance options? Below, we’ll explain three of the most popular types of car finance agreement.

Hire purchase

Firstly, there’s hire purchase (HP). With an HP agreement, the cost of your car and any interest is split evenly across monthly payments for the duration of your term. That’s typically between 3-5 years or 36-60 months.

Personal contract purchase (PCP)

PCP deals are a little different because a lump sum is required for a final balloon payment. This is optional, allowing you to purchase the car outright if you want – by making the payment. Alternatively, you can sidestep the payment and return the car to your finance company. As a result, monthly payments are lower on a PCP deal and there’s a bit more flexibility.

Personal contract hire

Finally, there’s personal contract hire. Rather than buying your new car, you pay to use it for the duration of your loan term. Monthly payments cover the car’s depreciation while you use it, plus interest. As a result, PCH deals often have the strictest mileage limits to protect the value of the car for the finance company.

Personal loan

Another option for financing a car is to take out a personal loan. Banks and credit unions may provide a good interest rate, particularly to customers or members with a good credit score. However, if you have a poor credit score due to bad credit history, you’re much less likely to be accepted for a personal loan by many banks and credit unions.

Tips for choosing the right car loan

All auto loans are designed to increase your buying power but not all contracts are created equal. When choosing an auto loan, it’s important to do your research and learn as much as possible before making a commitment. Here are some tips to help you understand how car loans work.

Sign on with a trusted provider

Your car loan experience can vary enormously depending on the provider you sign on with. When shopping around for car loans, trust and transparency should be front of mind. Reading reviews is a great way to get a genuine idea of what your preferred lender is like. You can also look for car finance platforms backed by trusted names. For example, Evolution Funding.

Read the small print

No matter how confident you are in your lender, it’s always advisable to read the small print before signing on the dotted line. You never know what could be hidden in the terms and conditions.

Ask questions

A good lender should be happy to answer all your questions without hesitation, no matter how big or small. Ultimately, asking questions about how car loans work will help give you total peace of mind.

Set up a direct debit for repayments

We get it, life can get busy and sometimes loan repayments can slip your mind. That’s why it’s best to set up direct debits for your loan repayments. This way, you’ll never have to worry about remembering to transfer instalments to your lender. Instead, the money will simply come out of your account each month.

As well as making your auto loan experience as streamlined and stress-free as possible, setting up a direct debit will ensure you don’t miss any repayments. This is the last thing you want as missed instalments can have a negative impact on your credit history. This leads on to our next tip – never bite off more than you can chew when it comes to car loans.

Borrow a sensible amount

Before committing to a car loan, it’s important to crunch the numbers and make sure your loan is realistic and manageable. It can be tempting to borrow more to increase your budget but at the end of the day, you need to be able to manage your repayments with minimal stress.

Speak to our car loan experts

Want to know more about how car loans work in the UK? Whether you’re purchasing your first car or looking to upgrade your vehicle, we’re here to help. Get in touch with the My Car Credit team today to find out more about competitive car loans backed by an extensive and varied network of car finance lenders.