The practice of car loan providers giving higher sales commissions for higher interest rates is set to be banned. So how should you shop around for a car loan?
We explain all in this guide.
You might want to wait until next year...
The Financial Conduct Authority (FCA) announced yesterday that the practice of incentivising sales people to sell loans at higher interest rates will be banned
However, there is a six-month grace period while the FCA gives firms time to implement the new rules given the additional operational pressures the automotive sector is facing at the moment. Meaning the ban will take effect from 28th January 2021. When it comes into force, the FCA believes consumers will save between £100 and £200 on average on their car loan, with some set to save more.
While the practice is not universal, it may be shocking to learn that this goes on at all, let alone being “widespread”. So how do you make sure it’s not happening to you?
First and foremost, be prepared to negotiate and do shop around. A finance offer usually stands for a period of time, and even a “limited time offer” (an often-used sales tactic, according to Parkers) should give you the chance to see if you can do better elsewhere. Second, make sure you understand the total cost of borrowing alongside any other charges.
Work out how much buying the car will cost you overall
Don't forget that the cost of a car is much more than the purchase price or monthly loan cost. Find out how much the car will cost overall, including all running costs, such as the cost of fuel, tyres and other maintenance, tax, insurance and depreciation.
Depreciation is an especially easy figure to miss in your calculations as some cars hold their value better than others and you may be able to benefit from that when you sell the car. However, if you have underestimated the depreciation calculation, you may not get back as much as you hoped for, ultimately costing you more than you expected. Brand new cars tend to depreciate more than used cars, losing the most value most quickly in the first three years.
The Money Advice Service has a great tool for calculating all of these costs. If the car is five years old or less, you only need its registration number, but you can add details manually too.
Work out if you can afford it
Knowing how much something costs isn’t the same as whether you can afford it and there are many ways to finance a car, from a personal loan to specialist car financing packages. Make sure you know the differences between each and how that will affect the various ways in which fees and interest can be charged and when.
If you can fund part of the purchase in cash, that is a good way to reduce the amount you pay in interest. But before you spend all of your spare cash, think about how much you need to keep back for emergencies and unexpected circumstances. This is about getting the balance right as the more you put in upfront, the cheaper it will be overall, but you may be left with a car to deal with if you need to free up some cash.
You may choose to compromise on the car you really want in order to pay for it all in cash – this is undoubtedly the cheapest way but is unrealistic for most – or to make sure you don’t become burdened by the cost of the debt.
If using cash, you could choose to use a credit card to ensure you get purchase protections, but if you do this, it’s very important that you understand two things. The first is any surcharge applied for using your credit card as this will increase the overall cost of the car (though possibly by less than with a loan). The second is that you must pay it off straightaway to avoid incurring interest on your credit card. It’s also possible you won’t be able to use a credit card for the size of the purchase. If you have a 0% credit card with enough limit, you could spread the cost but this may also be risky if you think there is a chance you won’t pay it off in full.
Ways to finance a car purchase
With car finance, things can get complicated quite quickly and it’s easy to sit quietly trying to keep up while the salesperson or their finance team “works their magic” to see what deal they can get for you. They often use tactics such as needing to ask someone else for each small improvement in the deal, running upstairs, to another part of the showroom or calling another department to make you think they’re working hard to get the numbers to work for you, while you get increasingly weary of the process. Not all salespeople do this of course, and sometimes they will be genuine, but the best way to combat any poor tactics is to have done your homework first.
A personal loan for the full purchase price is relatively straightforward and more often than not cost effective if you are eligible, though you must make sure you understand the total cost over the full term of the loan and that you can afford the repayments – not everyone can borrow at the same interest rate.
Remember: the cost of a loan overall typically depends upon how long the loan will last (the loan term) as well as the interest rate (APR) – for each year that passes, you pay interest on the interest. Smaller loans and poorer credit ratings usually attract higher interest rates. You also typically need to arrange this before you go to buy, though this does mean you will be able to negotiate in the same way as a cash buyer (though this can have its limitations as finance deals can be more lucrative for dealers than cash) and considerably less tempted to overspend.
Specialist car finance is typically arranged at the point of purchase with the dealer. This also gives the opportunity to introduce complexity in the shape of down payments and deposits, balloon payments, GAP insurance, tyre insurance, special coatings, more insurances and even how you fund options if buying from new. Make sure you know what kind of deal you are discussing, which items are included in any finance deals, how much they will cost you and whether you really need them.
For example, GAP insurance covers the cost of the car if it is written off and the outstanding finance is more than the value of the car. Payment protection insurance covers you for certain circumstances if you can’t meet payments. Both are likely to have their limitations and may be expensive. Think carefully about what’s in it for you, what’s in it for the sales person (commissions are earned on lots of different aspects of the process), how you feel about the risk of not having various insurances and know what your options are should you miss a payment before you buy.
Hire Purchase (HP)
Hire purchase is a loan that is “secured” against the car itself. Meaning you don’t own the car until the final payment but are paying the full value of the car with the loan. There is usually a relatively small fee associated with transferring the car to you at the end of the loan period.
If you have a sudden change of circumstances and need to sell the car, you need to agree this with the lender. They will more often than not give you a settlement fee to end the loan, so you would need to be sure the sale price of the car will cover it. However, there is also the option if you have paid more than half of the debt just to return the car to the lender and walk away (providing the car is in good condition or you may need to pay for repairs). The fact the lender owns it means they may also repossess the car if you miss payments, much in the way a mortgage is secured against your house. However, this can be good news if you have difficulty with accessing a standard personal loan as the lender has a way of recovering some of their costs.
APRs vary and depend upon loan term, deposit amount and your credit rating. Healthy deposits often go hand-in-hand with lower interest rates.
Personal Contract Purchase (PCP)
PCP gives you a lot of flexibility but with this comes some complexity. You don’t own the car for the duration of the loan but have the option to buy it at the end of the loan period with a balloon payment. PCPs typically keep monthly payments lower as you’re not buying the whole asset (car) over the course of the loan.
As with Hire Purchase, you will need a deposit and the bigger the deposit the less you borrow.
The loan part is essentially funding the depreciation of the car over the term of the loan and you will pay interest on this over the term of the loan. This will vary according to the maximum mileage you agree. This is written into the contract and if you go over it, there will be an excess mileage charge at the end of the contract. Make sure you know how much this will be and don’t underplay your mileage to make the monthly payments cheaper as some excess mileage charges are eye-wateringly expensive per mile.
When you agree to a PCP, you will be given a fixed balloon payment amount based on what the car is likely to be worth minus the depreciation you have been paying at the end of the term – this is sometimes called the Guaranteed Minimum Future Value. At the end of the loan period, you can choose to pay this amount and keep the car, or return the car and walk away though any damage (unless you fix it first using a reputable repairer) or excess mileage will need to be paid for.
One of the reasons this can be complex is due to the number of moving parts. If you get an unbelievable APR, it’s more than likely that the balloon payment will be inflated to compensate for lost revenue and you’ll pay more overall. Or the trade-in price of your current car can be manipulated. This kind of recalculating, especially adding in and taking out extras can be done on the fly while you’re in the dealership to rework the deal and improve whichever part you’re objecting to. It can be hard to remain focused on the variations, so always check the total cost of your deal at every stage, as well as what you are getting for your monthly payments.
The car is typically expected to be worth more than the balloon payment so you can use the equity as a deposit on another car or pay the balloon and sell privately at the higher value. And if it isn’t, you just hand it back and make it the lender’s problem. You can also often refinance the balloon payment so even though that’s how much you need to pay, there are options to do this via another loan.
A lease plan also means you don’t own the car and as with a PCP are essentially hiring it for the duration of the term. Lease plans usually mean lower upfront deposits and lower monthly payments but may not be cost-effective overall as you you’ve not paid towards an asset with an associated value that you will own and you don’t have the option to buy it. At the end of the lease term, you hand the car back and walk away, provided there is no damage and you’ve not exceeded the allowable mileage. Or you may be able to extend the lease with a new finance deal.
Leasing is typically for new cars and for those who like to change their car regularly. Sometimes leasing includes servicing and other costs so you should look very carefully at the cost of leasing against other ways to finance a car and whether it suits your needs.
Finally, not all deals and dealers are bad. Dealers often have targets to meet and the nearer you get to their quarter end, the more likely you are to get a deal. Be prepared to haggle on the APR over the next six months as it is possible the dealer or salesperson can make an adjustment while they’re still incentivised to drive APRs up. If you are nearer the time they are worrying about their targets, they’re more likely to take a hit on the APR so they get the bonus of meeting their overall target. And never be afraid to ask questions or walk away from the “deal of the century” if you aren’t 100% sure of how it all works.
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