Whether taking out a loan or a line of credit, it accompanies a fair share of financial obligations. Understanding these commitments is crucial if you want to make sound decisions. One such obligation is the finance charge.

Finance charges are the cost of borrowing money. So, please read this blog to learn more about finance charges, how they work, methods to calculate them, and ways to avoid them before signing any loan or credit contract.

What Is a Finance Charge?

A finance charge refers to the cost of the money you borrowed from a lender, credit card issuer, or any financial institution for borrowing on credit. For instance, if you have a credit card and fail to make the minimum payment within the grace period, the issuer can charge an additional fee for the late payment.

A late-payment fee is one of many ways you encounter a charge. It comes in various forms. Any amount you spend apart from the principal amount borrowed, whether a business loan, a mortgage or a credit card, is considered a finance charge.

Any borrower who borrows funds or uses credit becomes liable to pay. These charges reduce the risk for lenders. In a way, lenders receive compensation for lending funds or extending credit to borrowers.

How Do Finance Charges Work?

They are usually included with each monthly billing cycle and can vary depending on the terms and conditions of your loan or credit.

The Truth in Lending Act of 1968 mandates that lenders disclose the charges associated with a loan or credit to the borrower before signing an agreement. It outlines the information a borrower must know before consenting. The act requires the lender to:

• Disclose the annual cost of credit to a borrower
• Provide essential information regarding the credit transactions
• Frame procedures to correct any billing error

What Is Included in a Finance Charge?

There is no exact or definitive amount. It's a broad term encompassing almost any direct or indirect charge a borrower pays. Some of the typical types include:

• 1. Interest rates: A percentage of the amount borrowed that is charged by the lender for letting you use its money.
• 2. Transaction fees: An expense paid each time a customer performs a transaction.
• 3. Appraisal fees: You pay an appraiser to assess the value of a property you are looking to buy.
• 4. Origination fees: An upfront fee ranging from 0.5 to 1% that a lender charges for processing a loan.
• 5. Other charges could include:
  • Loan fees
  • Cash advances on credit card
  • Credit Report fees
  • Required insurance premiums
  • Closing costs
  • Prepayment penalties
  • Annual Percentage Rates

What Are Some Common Methods used to Calculate Finance Charges?

Financial institutions, banks, or companies lending money use the charges to make a profit by lending loans and credits. They become a primary source of income for such institutions and entities. These charges are assessed against loans, credit cards, or lines of credit. These charges include annual fees for a credit card, account maintenance fees, account transaction fees, late payment for a credit card, or late-fee charges on loans. They also may be assessed when purchasing on credit or acquiring a loan for the reasons like:

• Interest rate percentage above 0% in account
• Account balance at the beginning of a billing cycle is more than 0
• No grace period for making a payment

How to Calculate Finance Charges?

Different creditors utilize various methods to determine the charges. Even within the same category of loans, the fees can be disparate and difficult to understand. Here are a few examples of more common equations to help you understand the costs of a loan you may be considering.

Credit Card charges: Multiply your average daily balance by the APR (Annual Percentage Rate) and the days in your billing cycle. Then divide the product by 365 (the number of days a year).
Credit Card Finance Charge = (Average daily balance x Annual Percentage Rate x Days in a billing cycle)/365

Loan charges: In the case of loans, you can calculate the total monthly payments, including interest, and subtract them from the principal amount. The difference will reflect the finance charge associated with the loan.
Loan Finance Charge = Total monthly payments - Principal Amount

Examples

Here are a few examples to simplify the concept:

Case 1. Finance Charge On A Mortgage

Suppose you take a mortgage loan from a financial institution for 30 years. You borrowed a total of $132,000. The bank informs you about the fixed interest rate of 7% you will have to pay when reimbursing the loan.

The additional $50,000 you pay is the finance charge (interest) incurred for getting a mortgage.

Case 2. Charges On Credit Cards

Let's say you charge $500 on a card. You pay $250 but need to pay the entire amount by the due date. Once the due date arrives, your balance will go down to $250. Your average daily balance will remain $250, with some charges imposed by the issuer if you do not use your card or make payments. Suppose you have 25 days in the cycle with 18% as the APR.

Here’s how the formula works:

$250 x 0.18 x 25 = $1,125
$1,125/365 = $3.08
Thus, $3.08 will be your finance charge in the subsequent statement.

How to Avoid Finance Charges?

You may have observed how charges will increase the amount you have to repay when borrowing money. Can you avoid these charges and optimize your personal finance? Some practices to help reduce or avoid them depending on your loan type.

Most credit cards allow you to steer clear of the interest and fees if you pay your entire statement balance before the due date. Then when your new billing cycle begins, you will start with a zero balance and zero interest charges. Always be sure and check the details of your credit agreement.

When you have longer-term loans like mortgages or car loans, you can save quite a bit by making additional monthly payments on your loan's principal. When the principal is reduced, the interest charges are reduced, and you will pay off your loan earlier than scheduled.

Conclusion

You should always understand the finance charges you incur when using loans or credit. It may not be possible to avoid or eliminate all finance charges. But you can apply some measures to reduce them. Maintaining a stable and positive credit score can significantly help you lower the finance charges associated with the lender. We recommend you always evaluate the fees before signing any loan agreement.