What is a Finance Charge?

Understanding finance charges

A finance charge is a fee that’s charged for the use of credit or the extension of existing credit. This charge may be a flat fee or a percentage of borrowings, though percentage-based finance charges are the most common. Typically these charges are aggregated cost that includes:

• The cost of carrying the debt (interest payments)
• Related fees (such as transaction fees, origination fees, account maintenance fees, credit report fees, or late fees)
• Loan fees, points, and finder’s fee
• Required insurance premiums (like private mortgage insurance [PMI])

Charges can amortize on a monthly or daily basis, and range from product to product or lender to lender.

Finance charges for services like car loans, mortgages, and credit cards, have known ranges and depend on the creditworthiness of the person looking to borrow.

How a finance charge works

How much you pay in a finance charge varies based on:

• How much money did you borrow
• If you carry a balance from one billing cycle to another
• Current rates (based on the Federal Reserve)
• Your creditworthiness (credit report and credit score)

You may pay a one-time fee or make recurring payments based on terms, or sometimes these charges are lumped into your total loan balance.

You may be asked to pay these charges lumped into your total monthly statement or bill, or you may have to pay the finance charges separately.

Types of finance charges

Finances charges are different for credit card companies vs. a mortgage or loans. For example, when applying for a credit card, common finance charges include:

• Purchase annual percentage rate (APR)
• Balance transfer APR
• Cash advance APR
• Transaction fees
• Activity fees
• Service fees
• Late fees

When applying for a credit card, check the pricing and terms sheet for any financial charges you may have to pay.

For larger transactions like a mortgage, there are more factors involved such as:

• Interest paid
• Origination fees
• Discount points
• Mortgage Insurance
• Appraisal fees
• Finder’s fees
• Carrying charges
• Other lender charges

Look in the Loan Calculations section of your Closing Disclosure for finance charges associated with your mortgage.

What does a finance charge include?

Calculating the exact amount of a finance charge can be complicated because it relies on several factors, including the type of loan, but can include charges like:

• Personal loan: Interest, credit report fees, filing fees, discount fees, etc.

• Auto loan: Interest, credit report fees, filing fees, discount fees, etc

• Mortgage: Total amount of interest plus loan charges (such as origination fees, discount points, private mortgage insurance, document preparation fees, etc.)

Some charges are not considered finance charges including:

• Annual fees
• Late fees
• Taxes
• Registration fees
• License fees

How to calculate a finance charge

One of the most important factors in calculating what you owe in finance charges is your financial health, such as your credit score and credit history. Analyzing your credit will determine how deserving you are in getting approved for new credit, like a credit card or loan, and the better your creditworthiness, the less you’ll pay.

Note that your creditworthiness is determined by factors like your credit score, the amount of your debts, the number of lines of credit you have, payment history, and other related considerations. A higher credit score means you’re more creditworthy.

Then, each financial institution has its terms and conditions for the products and services it offers, so finance charges can be dramatically different from one to another (even for the same loan amount). Credit card companies also use different methods to calculate charges, primarily based on when they pinpoint the amount of your outstanding balance.

For example:

• Ending balance factors in how much you’ve paid and new charges you’ve made from the start to finish of a billing cycle.

• Adjusted balance subtracts payments you’ve made during a billing cycle.

• The previous balance is based solely on what you owe at the start of a billing cycle.

• Daily balance multiplies each day’s balance by a daily interest rate to get a daily finance charge, added during the billing cycle to get a total finance charge.

• Average daily balance adds each day’s balance in a billing cycle and divides that total by the number of days in the cycle.

The average daily balance is the most common way credit card companies determine their finance charges. Check the back of your monthly bill to learn which method your issuer uses.

So, say your credit card’s APR is 17.99%. Start by dividing the APR by 365 to determine your daily rate, which in this case is 0.049% daily interest. Multiply the daily interest by the number of days in the statement billing cycle to determine your interest rate for each finance charge. If there are 30 days in the billing cycle, this would translate to a rate of 1.470% for the billing statement. Then, multiply this rate by the amount of debt that’s subject to your APR. So, if you owe $5,000, you’d be assessed a finance charge of $73.95 on your billing statement.

Why does it matter to check your finance charges?

If you can identify balance charges, you can better compare two similar debt options to determine which is better for your situation.

It can also help you determine whether paying finance charges even makes sense. For example, if you have to pay $50 in finance charges to pay off a $200 credit card purchase, it’s better to wait until you can purchase cash. On the other hand, if you’d pay $1,500 in finance charges over a five-year loan for a $10,000 vehicle that you need to commute to your job, the charges may be worth it.

Note that in some cases it may make sense to pay more finance charges due to other features in the loan, such as having a longer repayment period but a lower monthly payment. Knowing what you owe, when, and why can help you make the most informed decision.

How to avoid finance charges

You may not always be able to stop finance charges (though there are some you can bypass), but there are ways you can contain the damage that they can do. For example:

1. Pay off in full

The most way that credit card companies can calculate finance charges is by using the amount of your outstanding balance in a billing cycle. If the finance charge is being calculated based on your daily balance or average daily balance you likely can’t avoid the charges, but if you’re being charged on the amount of your ending balance or previous balance, paying off the balance in full can prevent these charges.

Plus, paying off your balance in full can also help your credit score.

2. Consider a 0% interest rate card

There are cards out there with 0% interest, though most require a balance transfer from an existing card to a new card (which in some cases you may be charged a balance transfer fee) and the 0% APR only lasts for a short period (typically 12 to 24 months). However, during this introductory APR period, you can save money on finance charges.

3. Avoid cash advances

Cash advances are essentially short term loans, coming with high interest rates and transaction fees. While this can give you a quick cash fix, the fees and interest you’ll pay taking out the advance will likely outweigh the benefit of having the cash.

4. Pay extra for principal loans

If you can, you may be able to get out of some of the finance charges that come with an auto loan or mortgage by paying more than you owe each month. Because the finance charge on these loans is tied to the amount of your outstanding balance, reducing that balance more quickly than the loan terms require can help reduce the amount of interest you’ll be charged.

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