Ready to dive into the nitty-gritty of car financing? Our guide, 'Understanding the downsides to financing a car', spills the beans on what to watch out for, so you can cruise through the process with confidence. Let's break it down!
The world of car finance
For many of us buying a vehicle is one of the biggest purchases we will make, second only to buying a house. The chances are, you’ll need to upgrade or change your vehicle many times in your lifetime. Not everyone has a lump sum to use for this, especially if your needs change suddenly. That’s where car finance can come in useful.
There are several ways to finance your vehicle. Whichever option you choose will have certain drawbacks that you might not be aware of so its worth arming yourself with the details of any disadvantages of car finance, allowing you to make an informed decision.
It’s worth remembering also that you can buy a vehicle outright with cash, if you are able to, and it will be cheaper than financing.
What is car finance?
Car finance covers the various loans available to you if you need to borrow money to buy or rent a new or used vehicle. The borrowed amount will be repaid by the borrower, usually monthly, over the course of the agreement at a pre-agreed interest rate. These agreements are normally between one and five years.
Common methods of financing a vehicle
Car finance includes four main types of finance. These are: personal loans, personal contract purchase, hire purchase (HP) and leasing or personal contract hire (PCH). We’ve included a basic table below outlining the differences between these types of car finance:
How does it work?
So, you want to finance a vehicle? The first stage is choosing a finance company to apply to. You won’t want to apply to too many so it’s worth doing some homework to work out which provider sounds like a good fit for you.
Once you apply and you receive an approval, the lender will provide you with the agreed term of the contract and the monthly payment amount, including the APR. This is the applied interest rate added to the loan amount. This will typically be fixed. At this point you will have signed an agreement covering the terms and conditions of your loan. It’s important that you familiarise yourself with this detail.
Exploring the disadvantages of car financing
So far so good. But there may be aspects of car financing which might not suit you or that you may not have been aware of. Let’s look a little closer at the common disadvantages of financing a vehicle.
Interest rates
The first thing you should be aware of is the role of interest rates in your agreed monthly payment amount. Interest is the cost of borrowing.
The amount of interest you are charged will be determined by your credit worthiness and general financial health. Lenders use different criteria to do this but generally the better your credit score the lower your APR.
Impact on your credit file
Although no one sets out to miss a payment, the impact of it should be considered when choosing to take out finance. If you were to default on your loan, meaning the finance provider closes your account because of missed payments, this will leave a mark on your credit file for up to six years. This can be seen by other potential lenders and may impact your ability to get credit in the future.
Hidden costs of car finance
The details of any additional costs will always be covered in the terms and conditions of your contract but its worth looking at those ‘what if?’ potential costs – an early settlement fee, for example if you decide you want to end your agreement – in a little more detail.
Modifications
With PCP or HP, you won’t own the car until you make your final payment, and you pay your balloon payment or option-to-purchase fee. That means you can’t modify the vehicle in any way. You are also duty bound to keep it serviced regularly and in a good state of repair. If your circumstances change and you are forced to give up the vehicle you will have to pay for any modifications to be removed.
Mileage
Some types of finance such as PCP will dictate a mileage limit you must abide by. You may not plan to go over the number of miles you agreed to in your contract but if you do, for whatever reason, then the finance provider will charge you at a pre-agreed amount which can often feel quite high.
Early repayment and termination fees
Depending on the type of finance you choose to take out you’ll be subject to certain fees if you decide you want to withdraw from the agreement. Lenders will charge a fee to compensate them for financial loss they incur when you end the contract early.
Tips for navigating car finance challenges
Choice of finance
Some forms of finance will be better suited to your situation and any plans you may have for the future. For example, if you aren’t feeling as confident about your future budget then maybe leasing is a better option. Or maybe you know you would like to modify your vehicle straight away so a loan that allows you to own the vehicle outright would suit you better.
Online finance calculator
You can use a car finance calculator to test different terms and amounts, so you are clear on the cost of the finance. Most providers will have a customised calculator on their site to allow you to do this. Generally, the longer the term the higher the interest rate and therefore the overall cost of the loan.
Use a budgeting tool
You will give yourself the best chance of futureproofing your borrowing by taking a detailed look at your income and expenses. You will find plenty of options online. Be as honest as possible about your spending habits when filling these in so you understand exactly how much your budget should be.
Keep your credit score in good shape
Your credit score is one of the main ways a car finance provider will assess your application and will have an impact on the APR you will receive. The following points will get you off to the right start:
Register on the electoral roll. If your name’s not on there, you’ll find it much harder to get credit.
Pay your bills on time. This proves to lenders you’re capable of managing your finances.
Keep your credit card low. Try and keep your credit utilisation at 25% or lower.
Check if you’re linked to another person. Even if they’re your loved one, if their credit rating is low and you have a joint account it could have an impact on how a lender views you.
Clear any existing debt. Lenders are less likely to lend to you if you already have a lot of existing debt.
