Buying a car, whether new or used, is a big financial decision. For many, car loans provide a quick and practical way to spread the cost. But how exactly do car loans work, and what are your options when financing a vehicle? In this guide, we delve into everything there is to know about car loans and explore how they differ from other car financing options.
Car loans usually refer to an unsecured personal loan (UPL) that’s specifically used to buy a vehicle. The lender provides you with the funds in a lump sum, and you buy the car outright. You agree to repay the lump sum back in monthly instalments over an agreed period of time, usually with added interest.
Car loans are available for both new and used cars, and you can choose the loan term to fit your budget. You can use a car loan to pay for the full cost of the car, or to put towards a deposit.
Because car loans aren’t secured against the car, you are free to sell, trade in or modify your car as you like.
What is the difference between secured and unsecured loans?
Personal loans can be either secured or unsecured. A secured loan is one that’s attached to an asset – i.e. a physical object of value, such as a house or a car. An unsecured personal loan has no asset attached to it.
Secured Loans | Unsecured Loan |
|---|---|
A secured loan is where an asset you own, like your house, is used as security by the lender. If you don’t keep up with payments, the lender can take that asset to get their money back. Mortgages are a common example of secured loans - your home is used as security. A secured loan is typically used when you need to borrow a larger amount or if your credit score doesn’t meet the threshold for an unsecured loan. | An unsecured loan doesn’t need any asset as security. With an unsecured car loan, you get the money to buy the car yourself, so you own it from day one giving you full ownership without any collateral tied to the agreement. The lender can't take the car back if you fall behind on your payments, but they could pursue legal action against you. Because there’s no security for the lender, these loans usually have higher interest rates, to cover the extra risk. Although if you have a strong credit score you might have access to more favourable rates. |
Read more about the differences between secured and unsecured loans in our guide: Banking choices: secured vs unsecured loans.
Types of car loans
The car loan you choose will depend on a number of factors, including the type of car you want to buy and your personal financial situation. Here are three main types to consider:
New car loans
A new car loan is a UPL that is used to buy a brand-new car. The amount you can borrow will depend on the cost of the car and repayment terms can be chosen from between one to seven years. New cars are generally more expensive, so you may need to borrow a larger sum. Lenders may have stricter eligibility criteria for higher loan amounts
Used car loans
A used car loan is a UPL that you use to purchase a second-hand car from a dealer or private seller. They can be arranged over a set term of anywhere between one and seven years. For more information about financing a used car read our guide to used car finance.
Refinance car loan
Using a car loan to pay off an existing car finance deal is also an option. Circumstances change, and sometimes you may need to end an existing finance agreement by absorbing it into a new one. This can be a helpful way to:
Secure better interest rates and make your repayments more affordable
Reduce or extend your loan term
Switch from one type of finance to another
Car loans have several long-term benefits for today’s car buyers:
Affordability: Spread the cost of your car over manageable monthly payments. This makes it possible to afford to buy high-value cars without paying the full price in one go.
Flexible terms: Choose repayment terms that fit your budget, typically ranging from 12 months to seven years. If you choose a longer term your monthly payments will be smaller but you will pay more in interest over the lifetime of the loan.
Immediate ownership: With most UPL agreements, you own the vehicle outright as soon as you’ve paid for it with your loan, unlike other finance options such as HP or PCP in which the vehicle belongs to the lender until you’ve made all of the payments. With a UPL, your monthly payments then go towards paying off the loan, not the car.
Access to more competitive interest rates: If you have a strong credit score and a solid repayment history, you're more likely to qualify for the most competitive rates available. Take a look at our interest rates guide to learn more.
Increase your buying power: If you already have some money set aside to put towards buying a car, you can combine that with a car loan to increase your budget.
Build your credit score: Making regular payments on time and in full will steadily build your credit rating, opening doors to more competitive interest rates should you require finance in the future.
While personal loans offer several benefits, it’s important to keep in mind that these car loans can come with higher interest rates and larger monthly repayments. And with a UPL, if you fall behind on your payments, whilst the lender won’t repossess the car, they may be forced to take legal action to recover the debt if the situation worsens. Therefore, it’s important to weigh up your options and choose the finance option that best fits your personal financial situation.
There are three main factors to consider that will affect how much you’ll pay each month.
Car loan amount
This is the total amount you borrow to buy the car.
The exact way your monthly payments are calculated may vary by lender. Roughly, your monthly payments are made up of the total amount you borrow, plus the interest, divided by the number of months in your loan term. There may also be one-off fees at the start or end of your agreement.
The total amount of interest that you pay across the life of the loan will always be shown as an APR - this is to make it easy to compare offers across different lenders.
Representative Example: Borrowing £10,000 over 60 months with a fixed interest rate of 14.7% per annum and a representative APR of 14.9%, your monthly repayment would be £232.53. The first payment would be £282.53, which includes a £50 opening fee. The total cost of credit would be £3,900.00, making the total amount payable £13,900.00. The representative APR includes all interest and fees.
The car loan annual percentage rate (APR)
APR is a calculation that allows you to understand the total cost of borrowing over a year. It’s a percentage of the money you’ve borrowed that includes the interest rate and any fees attached to the loan; it’s a helpful way to compare the total cost of different loans. Find out more about interest rates and APR.
There are a number of factors that a lender will take into account when calculating your APR, but generally, the better your credit rating, the lower your APR will be. A lower APR means a lower interest rate, which will reduce your monthly payments.
Car loan term
The loan term is the length of the loan. This can be anywhere between one and seven years.
The longer the loan term the smaller the monthly repayments will be, but the greater overall interest you will pay. Shorter loan terms have higher monthly payments but save on interest, so actually cost you less overall. It’s essential to find the right balance to suit you and your circumstances to make sure your loan is affordable.
Use our car finance calculator to try out different loan amounts and loan terms to help you decide what works best for you.
Work out your budget: Decide how much you can afford to pay back monthly. Don’t forget to factor in insurance, running costs, maintenance and depreciation into your overall costs.
Choose the amount you would like to borrow: You can work this out by subtracting the amount you have saved from the value of the car you’d like to buy.
Select a Loan Term: This is the length of time it will take to repay the amount you’ve borrowed. Payments are usually made monthly.
Approval Check: Lenders evaluate your credit score, income, and financial history to determine your eligibility and the interest rate offered.
Loan Offer & Funding: Once everything has been confirmed, the lender will transfer the money to you so you can buy the car.
Repay Your Loan Monthly: Begin making monthly repayments. Each installment includes part of the loan principal and interest.
Yes, there are other ways to finance a car, and it’s important to research all your options to help you work out which one suits you best. Aside from car loans, the main car finance alternatives are hire purchase (HP), personal contract purchase (PCP) and personal contract hire (PCH). If you are looking to borrow a large amount, you might want to consider one of these car finance arrangements.
Hire purchase (HP)
Hire purchase is often referred to as traditional car finance. With a HP agreement you make a regular monthly payment while using the car. The car is owned by the finance provider until you have paid off the loan in its entirety, plus a final ‘option to purchase’ fee.
How it works: You make an initial deposit (usually 10%) and then pay fixed monthly instalments over a set period (usually 1-5 years). Ownership transfers to you after the final payment.
Pros: Simple to understand, no mileage restrictions, and you own the car at the end.
Cons: Higher monthly cost compared to other finance options like PCP, and you don’t own the car until the last payment. If you miss your payments the lender could take back the car.
Personal contract purchase (PCP)
With a PCP agreement you borrow an amount equal to the estimated depreciation (the predicted value of the car at the end of the contract) of the car you want to buy. This means that your monthly payments are smaller. As with an HP deal, the lender owns the car until you have paid back the loan in full. If you want to keep the car at the end of the loan term, you need to pay an extra amount, known as a ‘balloon payment’ - which can be a significant lump sum.
How it works: You pay lower monthly payments compared to HP, but a large balloon payment is required at the end if you want to own the car. Alternatively, you can return the car or trade it in for a new PCP deal.
Pros: Lower monthly payments and flexibility at the end of the term.
Cons: Mileage restrictions during the term, and a higher final payment if you choose to buy the car at the end.
Personal contract hire (PCH)
A PCH deal is a popular way for you to lease a car with no option to keep it. Monthly costs can be lower, but extra charges often apply.
How it works: This is a long-term rental agreement where you pay to use the car for an agreed period and then return it at the end.
Pros: Fixed costs, no depreciation worries, and the option to drive a new car regularly.
Cons: You never own the car, and there are mileage restrictions and potential penalties for wear and tear.
Car financing options at a glance
Personal car loan | Personal Contract Purchase | Hire purchase | Personal contract hire | |
|---|---|---|---|---|
Typical length of agreement: | 1-7 years | 1-5 years | 1-5 years | 1-4 years |
Initial deposit required? | No | Usually but not always | Usually but not always | Usually but not always |
Who owns the car? | You, although you will still need to repay the debt | The lender or finance company unless an optional final balloon payment is made | The lender or finance company until final repayment plus option-to-purchase fee is made | The lender or finance company, always |
Mileage restrictions | No | Yes | Sometimes | Yes |
Final thoughts: Is a car loan right for you?
Choosing a car to buy and deciding how to finance it requires careful thought and research.
Car loans provide a fast and effective way for drivers to finance their vehicles, offering flexibility and a range of options to suit different needs. By understanding the differences between secured and unsecured loans, new and used car financing, and alternative finance options like HP, PCP, and PCH, you can make an informed decision that suits your budget and lifestyle.
As with any major financial decision, take the time to shop around and ensure you fully understand the terms before committing to a car financing agreement.
