One of the big decisions families or individuals may have to take when it comes to spending money is on how to finance a new car purchase.

While some may be in a position to fully buy outright, it is estimated that over 80 per cent of new car purchases are made using some form of financing – well over two million cars a year, old or new, are bought this way in the UK.

It’s important when deciding which route to take that you never agree to anything you don’t fully understand or that you feel you’ve been pressured into choosing or signing for, while you should also make sure the repayments are within your planned budget.

Here’s everything you need to know around what type of car finance agreement might suit your needs.

Is PCP car finance a good idea for my budget?

First of all, PCP stands for Personal Contract Purchase. It’s one of the more popular ways to buy a car, but does take some understanding to get the full picture.

Essentially there are three main payment parts to any such arrangement: initial deposit, monthly payments, and the final balloon payment.

Some important points to note are that you won’t own the car until you make the final balloon payment, but you will be responsible for running costs including insurance, fuel, replacements/repairs and so on. Therefore, when considering your budget, don’t just factor in the monthly payments – you must be sure you can manage the ongoing costs too.

Additionally, you’ll need to pass a credit check when applying, which will leave a record on your credit file.

The exact details depend on any agreement with the dealer, but terms of around three to five years are popular.

Then, the initial deposit could be around 10 per cent of the car value, with the balloon payment being the final large payment set by the company financing your purchase. If you make that optional payment, you’ll own the car; if you decide against it, you won’t and must hand back the vehicle. You could also arrange a new finance deal in some cases.

In between, there are the monthly payments to make. This amount will be the value of the car minus your deposit and planned balloon payment, but with interest on top. The interest is calculated on the value of the car minus the deposit.

As vehicles, like many other assets, depreciate across the term of their life, the balloon payment should be valued on the expected value of it at that time: the Guaranteed Minimum Future Value (GMFV).

Once you know the details of a potential PCP deal you can use free online calculators to make sure you understand exactly how much your repayments might be, as well as the full cost you’ll pay over the deal (not including running costs) so you can compare that to the actual price and value of the car.

You should always expect your dealer to be able to explain the full contract clearly to you including terms and clauses.

As one example, you will usually have annual mileage clauses in your contract. Make sure to arrange limits which work for your needs and balance that against higher costs. Gap insurance is another term to fully understand if offered it, regarding if you owe more than an insurance payout gives you in the event of theft or vehicle write-off.

Is HP car finance a better financial option?

Hire Purchase (HP) is a similar option, but without the final balloon payment at the end – therefore the monthly payments are higher as you pay the entire amount – less the initial deposit – across the term of the contract.

Of course, that includes interest payments. The way to lower those is to have a higher deposit amount at the start, or negotiate a better interest rate.

At the end of your repayments, you may have a final payment to make as an “option to purchase” fee, perhaps around £100, then you will own the car outright.

FCA redress scheme for PCPs and HPs

In the UK, PCPs and HPs have been at the centre of attention for mis-selling of finance and commissions within them prior to 2021, with some consumers eligible for compensation.

While a full rundown of the issue is beyond the scope of this article, before then, brokers could adjust interest rates to claim higher commissions under a process which is now banned. Those who were affected by it may be able to claim compensation.

It’s important to note, you do not need to use a claims management company. You can claim yourself for free or directly with your lender or the financial ombudsman service.

However, if you want to find out more about claims management companies then here are some CMCs that are authorised by the FCA:

What other types of car finance are there?

You’re not restricted to these methods when buying a car and depending on your situation, there may be better or simply different options available to you.

A personal loan is another alternative; in practice when going to the dealer this means you become a cash buyer, as you pay them with the money taken out in your personal loan. The loan itself you would then repay to the bank or lender, under the terms of your agreement. You should therefore ensure the terms are favourable to you when compared to, for example, a hire purchase.

Personal leasing is another option, similar to HP but without the prospect of owning the car at the end. Once the arranged repayment period is completed, the car is handed back to the dealer, which owns the car throughout.

Additionally, a newer method which is available on some occasions is a subscription style arrangement – this can offer more flexibility and choice, but repayments may work out more expensive over the long term and while you may not have ongoing running costs, you will not own the car outright.

As ever, you should ensure your eventual choice is the right one for your circumstances, not just financially but regarding ownership and timeframes.