There’s a lot of information to gather before you can borrow money. Whether you’re taking out a mortgage, applying for an auto loan or opening a new credit card, it’s essential to know what to expect upfront.
Most importantly, you’ll need to figure out exactly how much a loan or other financial product will cost. This is where finance charges come in.
Let’s explore finance charges, how they work – and how you can avoid them.
What Is a Finance Charge?
A finance charge – which can be a flat fee or a percentage – is the amount of money you pay to borrow funds from a lender, credit card issuer or other financial institution.
A common misconception is that a finance charge means interest. Finance charges are more than interest. They can include a combination of interest and fees.
If you’re trying to figure out which costs are included with finance charges, here’s a helpful trick: Finance charges typically represent costs you wouldn’t incur if you were paying with cash instead of credit.
Finance charges and the Truth in Lending Act
Lenders and card issuers have to disclose finance charges in writing before you can borrow money. This requirement is thanks to a federal law known as the Truth in Lending Act (TILA).
TILA was passed in 1968 and was implemented by the Federal Reserve Board’s Regulation Z the following year. One of the primary purposes of TILA is to protect consumers as they work with creditors and lenders.
TILA also makes it easier for consumers to compare credit by standardizing terminology and the way rates are disclosed. Finance charge disclosures are designed to help consumers know how much a financial product will cost them.
Because the disclosures are standardized, borrowers can make apples-to-apples comparisons when they’re searching for the best deal on financing.
What Does a Finance Charge Include?
Coming up with the exact dollar amount of a finance charge can be complicated. According to the Federal Reserve, a finance charge doesn’t include every cost involved with obtaining consumer credit.
Regulation Z provides examples of finance charges, including:
- Interest fees
- Service fees, transaction fees, activity or carrying charges
- Loan fees, points and finder’s fees
- Appraisal fees, origination fees and credit report fees
- Required insurance premiums, like private mortgage insurance (PMI)
Regulation Z also provides examples of charges that are not considered finance charges, like annual fees or late fees on a credit card, taxes, registration fees or license fees.
Here’s how finance charges may be calculated on a few common loan types:
- Mortgages: Finance charges may include the total amount of interest plus any loan charges, including origination fees, discount points, private mortgage insurance, document preparation fees, etc.
- Auto loans: Finance charges may include interest, credit report fees, filing fees, discount fees, etc.
- Personal loans: Similar to auto loans, finance charges may include interest, credit report fees, filing fees, etc.
How Do Finance Charges Work?
Finance charges compensate lenders and creditors for lending money and protect them in case borrowers fail to make their payments.
Although what each lender and creditor include in their finance charges is at their discretion, they must follow the standards for disclosure if they fall under the categories outlined in Regulation Z.
While there is a standard to disclose finance charges, there isn’t a stand-alone formula for calculating each of them. How much you pay in finance charges can vary based on:
- The amount of money you borrow
- If you’re carrying a balance from one billing cycle to the next
- Current rates (based on the Federal Reserve)
- Your creditworthiness (aka your credit report and credit score)
Depending on the type of finance charge, you may pay a one-time fee or make recurring payments based on the lender’s terms (like once a month or once per billing cycle). And, sometimes, finance charges are lumped into your loan balance.
Finance charge example
Let’s take a look at a simple example to make this concept a little easier to digest.
Say you want a personal loan for $1,000, and you’re looking at the finance charge disclosure for two loans:
Lender A charges:
- $2.50 monthly service fee
- $10 origination fee
- $20 credit report fee
- 5% interest rate
Lender B charges:
- $3.00 monthly service fee
- $10 origination fee
- 7% interest rate
This example illustrates how finance charges can vary between lenders even when you’re looking at similar products (in this case, personal loans). It also shows how the amount you pay for each charge can vary. You can see that Lender A has more finance charges, but Lender B’s finance charges cost more.
What Is a Finance Charge on a Credit Card?
With certain financial products, like most loans, finance charges tend to be automatically included in the cost of financing once you sign your loan papers. But, typically, credit cards work differently.
With credit cards, you may not pay any finance charges if you pay off your entire balance within your account’s grace period (think: by your statement due date). However, if you carry a balance from one billing cycle to the next, extra finance charges may be added to what you already owe, and you’ll find them on your monthly statement.
The amount of your credit card finance charge will depend on:
- Your credit card balance
- Your annual percentage rate (APR)
Credit card finance charge formula
Credit card interest is the most common finance charge for credit cards. When you carry a credit card balance from one billing cycle to the next, you’ll usually incur a finance charge.
Credit card issuers calculate finance charges in a variety of ways. To discover the method your card issuer uses, you should consult your cardholder agreement.
Average daily balance method
One common approach to calculating finance charges is known as the average daily balance method. Here is the formula:
Finance charge = (average daily balance X annual percentage rate X number of days in billing cycle) / 365
To use the formula, you’ll need to calculate your average daily balance first. To do that, you’ll add up your balance from the end of each day in your billing cycle, then divide the result by the number of days in the billing cycle. That’s your average daily balance.
Now let’s calculate the finance charge. Let’s say your average daily balance is $1,000, your APR is 20% and there are 30 days in the billing cycle.
(1,000 X 0.20 X 30) / 365 = $16.44
So your finance charge would be $16.44.
How Do I Avoid Finance Charges?
With credit cards, you can generally avoid finance charges if you pay off your full statement balance by the due date. If you fail to pay off the entire balance within the grace period, interest (among other finance charges) will be applied.
There are at least two common exceptions to this rule. If you use your credit card to take out a cash advance, you may pay a finance charge even if you fully repay the advance by your due date. And unless you have a 0% transfer rate, balance transfers may start accruing interest immediately as well.
Installment loans are another matter. When you take out the loan, you generally agree to pay certain finance charges upfront or with your monthly payments. If you can pay your loan off early, you’ll save some of the money you would have paid in finance charges over the life of the loan.
While you may not avoid finance charges in every situation, you may be able to lower your finance charges by getting a lower interest rate, taking out a loan to pay your balance or transferring a credit balance to a card with lower fees. Take a look at finance charge disclosures to compare.
Finance Charges Disclosed
Finance charges are the cost of borrowing money and can vary depending on key factors like how much you borrow, current rates, which lender you choose and your credit score.
TILA requires lenders and creditors to disclose any charges that fall under Regulation Z before you borrow money. This makes it easier for you to compare credit products and know exactly how much borrowing will cost you.
You may be able to avoid finance charges on credit cards by paying your balance in full each month by the due date. And while you usually can’t avoid finance charges on installment loans, you would pay less in charges if you paid off the loan early.
Consumer Financial Protection Bureau. “Truth in Lending Act.” Retrieved June 2022 from https://files.consumerfinance.gov/f/201503_cfpb_truth-in-lending-act.pdf
Consumer Financial Protection Bureau. “12 CFR Part 1026 – Truth in Lending (Regulation Z).” Retrieved June 2022 from https://www.consumerfinance.gov/rules-policy/regulations/1026/