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What is a finance charge?

When you take credit or borrow money, then the lender will charge money for lending to you. This is known as a finance charge. It is the cost of borrowing money or using credit. Apart from the interest paid on the amount borrowed, it also includes other fees. A finance charge is usually calculated as a percentage of the total amount borrowed. In some cases, it may also include a flat fee. The finance charge levied depends on the type of borrowing. The way finance charge is calculated for credit card balance is different from how it is calculated for a home mortgage.

Interest and finance charge

Interest is money charged by a lender in return for lending you a sum of money. Interest is one of the components of the finance charge. In most cases, it is the major component. Interest is calculated as per the APR (Annual percentage rate). In most cases, the APR is a percentage levied on the credit taken. Finance charge includes the interest. It also includes other charges like late fees and penalties, underwriting fee, annual fees, etc.

How it is calculated?

Let’s see how finance charge is levied. We will take the example of a credit card to understand more about finance charges.

A credit card is a facility given where you can spend money on credit, i.e.: by borrowing it from a bank or financial institution at the time of using the card. Every month the card issuer will send you a bill with the details of your spending and the finance charge for that month. Most credit cards allow for a grace period. This may range from 21 to 45 days, depending on the card issuing organization. If you repay the credit you took within this grace period, there is no finance charge levied. However, once the grace period is up, you will be levied a finance charge.

Let’s assume you spend $1000 on your credit card. In the bill you get, the card issuer asks you to pay a minimum amount on your due, which is usually 2% of the balance. So, you need to pay $20 for that month. That would mean you have a balance of $980 on your bill. Finance charge is levied on this amount. Finance charge is usually levied on the average daily balance. You may have a balance pending from the previous month. Additionally, you spend money in the present month.

The balance amount may keep changing throughout the month. The total sum of the daily balance is calculated and divided by the number of days in the month. This would give you the average daily balance. Finance charge is levied on this amount.

For instance, your average daily balance for a month maybe $1000. Let’s see how the finance charge is calculated. There are two factors used to calculate the finance charge. They are:

  1. APR: The annual percentage rate, which is decided in advance by the card issuer.
  2. Billing cycle: The number of days in the billing cycle.

Let’s assume the APR is 18% and billing cycle is 25 days.

Your finance charge is calculated as Average daily balance x APR x billing days / 365.

In this case, it is 1000 x 18/100 x 25 / 365 = 12.33

So, your finance charge for the month is $12.33, which is included in your monthly bill.

This includes only the interest component. There could be other charges also. For instance, if you do not pay up by the due date, you may be levied a late fee. It usually is a flat amount, maybe $25. This is added to the finance charge. On the last month of the year, you may be charged an annual membership fee. This is added to the finance charge for that month at the time of billing. The other fees a credit card issuer might charge include transaction fees if you take a cash advance using your credit card. If you exceed your credit limit, charges will be levied on that.

If you borrowed money for a home mortgage, then the finance charge would include the following:

  1. Interest, which is the fee charged by the lender who offered you a mortgage.
  2. Origination fees paid to the lender to process your application.
  3. Discount points, which is prepaid interest to lower your monthly payment.
  4. Mortgage insurance, that is insurance to protect your lender in case you default.
  5. Any other charges as decided by the lender.

How is the finance charge decided?

The finance charge is decided by the lender based on the lending company’s policies and keeping in mind market trends. If all lenders in the market offer a mortgage at 4%, then obviously anyone charging more than that will find it difficult to find a borrower, so the mortgage rate has to be fixed as per market rate or lesser than that. The finance charge may not be a fixed amount and may vary. For instance, to get a car loan your credit score will be verified. If you have a poor credit score, then the lender will charge a higher interest rate to cover the risk of lending to you.

While lenders can decide the finance charge for the amount they lend on credit, they need to be upfront about it. The Truth in Lending federal act makes in mandatory for lenders to disclose all charges levied to borrowers. Interest, annual fees, penalty, and all other fees need to be informed in advance to the borrower. In case a lender changes any fee, it has to be informed to the lender.

The finance charge is levied by a lender to cover the risk taken by lending money to a borrower. Apart from interest, it also includes other charges as decided by the lender.