How Does A Car Finance Work?

Car Financing has come to the rescue of many drivers who cannot afford to purchase their cars from their savings. So if your account balance makes it impossible to pay for your dream car upfront, then going for a car finance may be that gate way you need. But how exactly does a car finance work?

Well, I’ll be explaining in detail how car finance works in the subsequent paragraphs in oder for you to have a good understanding of the topic to make your car financing decision a lot more easier for you.

So let us first understand what Car Finance is.

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What is a Car Finance? 

According to Wikipedia, Car Finance is basically “the various financial products which allow someone to acquire a car, including car loans and leases”.

The term Car Finance and Car loans have been used mostly to mean the same thing when they are not. Car loans in itself is a form of car finance but the two are not the same. So it’s safe to say Car loans is a subset of Car finance.

Whereas car loans can only be obtained from either a bank or credit union, Car Finance on the other hand can be obtained from the dealership or auto finance companies.

A typical Car finance can either be a Lease, Hire purchase, Car Loan or a Personal Contract Purchase and you must understand how each of them works before deciding on which option to use to finance your car.

How Car Finance Works 

Unless you are going for a car loan which can only be obtained from a bank or credit union, all the other options are offered by the dealer or auto finance companies.

With car loans, you go directly to me your lender (bank/credit union) to borrow money to purchase your car. However, with car finance, it is usually the dealer who arranges for financing for you.

Most of the dealerships have a number of auto finance companies they work with to provide financing for customers who need it. Others also have an auto finance division as well where you can obtain financing. So what they do is that, when you decide to purchase a car from them but is unable to pay upfront for it, they help you secure financing because they have a working relationship with them and then you pay back over a period.

Some dealerships normally offer financing in order to make more sales. They may add a makeup to the rate that was initially offered by the lender hence resulting in a higher interest rate as compared to a car loan.

Now let’s look at the various car finance options:

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Car Loans 

Car loans is the loan given to you by a bank or credit union specifically to purchase a car. This loan will then be paid back in monthly installments over a period of 36 to 60 months or more in some cases.

Interest on car loans are relatively lower than the other types of car finance. And you also get the opportunity to compare rates of competing lenders which puts you in a position to negotiate for a better offer when you finally decide on which lender to go for.

However, your credit score must be as good as possible before you can get a car loan due to their strict credit score requirement. The process also takes a bit longer as compared to dealership financing.

Car Leases 

Car leasing is another way you can finance your car but you are not given cash to make a purchase as is the case in car loans. However, the car is leased or given to you for a number of years and then you make monthly payments for using the car.

During this period, you don’t really own the car and you’re restricted when it comes to the total distance you can cover in a year (usually not exceeding 12,000 miles). Your monthly payments, which is lower when you lease is arrived at based on the residual value of the car or an estimate of how much it will be worth when the lease is over.

At the end of the lease, you can choose to purchase the car.

Hire Purchase (HP) 

Unlike car leases, there are no mileage limits when you go for a hire purchase. With Hire Purchase, you can buy a car and pay back with interest in fixed monthly installments over a period till the end of your loan term.

However, you may be required to provide a down-payment in most cases before you can qualify for a hire purchase.

You only get to fully own the car after your debt is completely paid off. The dealership or auto finance company will have to repossess the vehicle if you fail to pay back.

Hire Purchase is a very common way of financing a car in the UK.

Personal Contract Purchase/ Plan

Personal Contract Purchase (PCP) is similar to a hire purchase. However, with PCP, the monthly payments you make are lower throughout the course of the loan term and then you make a balloon payment at the end of the loan term.

Both you and the finance company or dealer has ownership of the car until you make the balloon payment at the end of the loan term. After which you become the sole owner of the car.

However, if you fail to pay the balloon payment, the finance company can repossess the vehicle.

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Buying a car is a big deal, more so when you have to do it with a car finance. Despite the excitement that comes with owning your own car, always take some time off to really analyse things to find out if you really need a car desperately or if you have to do it through car finance.

If its possible to wait till you can pay upfront for it then wait. But if you’re still bent on getting financing, then your credit score must be good enough in order to be offered lower interest rates. Again, if your credit score isn’t good enough, then you may have to wait till your credit score is good enough.

Making down-payments also helps. It’s best if you can pay a huge down-payment in order to reduce your monthly payments and lower your interest rate as well.

I believe the above explanations gives you a good understanding of how Car finance work? Any additions or suggestions are welcomed.

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