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 up front.
Most importantly, you need to figure out exactly how much a financial product will cost you.
What Is a Finance Charge?
A finance charge is the amount of money you’ll pay to borrow funds from a lender, credit card issuer, or other financial institution. Finance charges can include a combination of interest plus additional fees.
Finance charge definition — the Truth In Lending Act
Lenders and card issuers have to disclose the finance charge in writing before you borrow money. This requirement is thanks to a federal law known as the Truth in Lending Act (TILA).
TILA defines a finance charge as “the cost of consumer credit represented in dollars and cents.”
TILA was initially enacted in 1968. The law 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 deal with creditors and lenders.
Finance charge disclosures are designed to help consumers when they’re shopping for credit products. So, TILA requires these disclosures to be uniform in nature. By keeping the disclosures the same, it’s easier to compare apples to apples when you’re looking for the best deal on financing.
What does a finance charge include?
Coming up with the exact dollar amount for a finance charge can be complicated. According to the Federal Reserve, a finance charge doesn’t include every cost that has to do with obtaining consumer credit. An annual fee on a credit card, for example, often isn’t added. Late fees aren’t usually part of a finance charge either.
Regulation Z, which implements the requirements of TILA, provides a few examples of the fees that might be included in a finance charge, such as:
- Interest fees
- Service fees, transaction fees, activity or carrying charges
- Loan fees, points, finder’s fees, etc.
- Appraisal fees, credit report fees, etc.
- Required insurance premiums (like private mortgage insurance or PMI)
What Are Finance Charges in Credit Card Accounts?
With certain financial products, like loans, finance charges are automatically included in the cost of financing once you sign your loan papers. But credit cards are different.
With credit cards, you may not have to pay any finance charges if you pay back the money you owe within the grace period on your account. If you carry a balance from one billing cycle to the next, however, extra finance charges may be added to the amount you already owe.
The amount of the finance charge will depend on two key factors:
- How much money you charged on your credit card (your balance)
- Your annual percentage rate (APR)
Credit card finance charge formula
When you revolve a credit card balance from one billing cycle to the next, you’ll usually be charged a finance charge (unless you have a 0% rate). Credit card issuers calculate finance charges in a variety of ways. To discover the method your card issuer uses to calculate finance charges, you should consult your cardholder agreement.
One common approach cardholders use for calculating finance charges is known as the average daily balance method. Here’s the formula used to calculate the finance charge using this method.
(Average daily balance X annual percentage rate X number of days in billing cycle) / 365
Before you can use the formula above, you’ll need to add together your balance from the end of each day in your billing cycle. Then, divide that number by the number of days in the same billing cycle. That’s your average daily balance.
Say your average daily balance is $1,000, your APR is 20%, and there are 30 days in the billing cycle. The formula and solution would be:
(1,000 X 0.20 X 30) / 365 = $16.44
So your finance charge would be $16.44 in this situation.
But remember, as long as you pay your full statement balance by the due date, you can generally avoid paying any finance charges on a credit card bill. If you follow this advice, your interest rate may not matter. In most cases, no interest charges will apply to your account that month.
There are at least two common exceptions to this rule, however. If you use your credit card to take out a cash advance, you may pay a finance charge even if you repay the money borrowed in full by your due date. Balance transfers may start accruing interest immediately as well, unless you have a 0% rate.
What Are Other Types of Finance Charges?
Aside from credit cards, other types of credit come with finance charges too. Finance charges are how lenders make money and, often, how they protect their investments.
Here’s how finance charges may be calculated on a few common types of loans.
- Mortgages: Finance charges may include the total amount of interest plus loan charges (e.g., origination fees, discount points, private mortgage insurance, document preparation fees, etc.). This is also known as your total cost of credit, and it’s included in your Truth-in-Lending disclosure.
- Auto loans: Finance charges may include any costs that you have to pay according to the terms of the loan. These costs may consist of interest fees, application fees, filing fees, etc.
- Personal loans: Finance charges include all interest and any fees that you must pay to take out the loan.
How Do I Avoid Finance Charges?
If you’re trying to figure out which costs are included in a finance charge calculation, here’s a helpful trick. Finance charges typically represent costs that you wouldn’t incur if you were paying with cash instead of credit.
With credit cards, you can generally avoid finance charges if you pay off your full statement balance by the due date. Fail to pay off your balance within the grace period, however, and interest will be assessed.
Installment loans are another matter. You generally agree to pay certain finance charges upfront whenever you take out the loan. Yet you may be able to pay your loan off early and save some of the money you would have paid in finance charges, depending on the terms of your agreement.