What Is a Finance Charge and How Is It Calculated?
Finance charges can encapsulate all of the costs associated with borrowing money. Here’s what you need to know.
December 22, 2021
Borrowing money always comes with a cost. In most cases, this is the interest rate, often expressed in terms of annual percentage rate (APR). But this is not always the only cost associated with borrowing money.
You may have heard the term “finance charge” or seen it on a statement or bill. But what is a finance charge, and what does it mean for your money?
What is a finance charge?
A finance charge is the cost of borrowing money. This can include interest, but also other associated fees and costs that lenders may charge, such as late fees and service fees.
Put simply, finance charges are how lenders make money. Without these fees and interest charges, lenders would have no financial incentive to issue loans.
Finance charges are added to the amount you borrow. This means that you will eventually pay back the entire original amount borrowed plus any finance fees, including interest.
A finance charge could be a flat fee, or it could be a percentage of the borrowed amount. Percentage-based fees, expressed in terms of APR, are most common.
Lenders are now required by the Truth in Lending Act to make finance charges clear for borrowers.
When you shop around for a loan, you’ll be given detailed information concerning cost and any applicable finance charges. Likewise, credit card statements and statements for loans will include information on the interest and other fees.
You can ask your lender directly if you’re wondering how to find finance charge information for your loan.
What is not a finance charge?
Finance charges are only costs that relate to borrowing money. Other associated fees from banks, such as checking account maintenance fees, ATM fees, etc., are not generally considered finance charges.
What types of loans have finance charges?
Any time you borrow money, you will likely pay finance charges. The only exception is if you get an interest-free loan from a family member, or perhaps through a special government or grant program.
Some of the types of loans with finance charges include:
Lines of credit
There are detailed regulations set out by the government concerning finance charges and what is and is not allowed. These regulations can differ depending on the type of loan.
For example, the CARD Act established the rule that there must be a minimum 21-day grace period before interest charges can be assessed on credit card transactions.
Finance charge vs. interest rate
As we described above, finance charge is a broad term that can include many different charges, including interest.
Interest is charged on most loans and the percentage can vary greatly. For instance, a credit card may have an interest rate of 19%, and a mortgage may have an interest rate of 3.5%.
Mortgages have lower interest rates because the debt is secured. If someone defaults on a mortgage, the bank can actually take ownership of the house. This reduces the bank’s risk.
On the other hand, credit card interest is much higher because the debt is unsecured. The lender cannot reclaim items that someone purchased with the card — and often, credit card debt may be from purchases of consumable items like groceries.
Interest is usually expressed as annual percentage rate, or APR — although there are subtle differences between the terms “interest rate” and “APR.” Put simply, APR is a broader term that can include the interest rate plus other charges that are required to get the loan.
For example, a mortgage may have an interest rate of 3.5%, but when factoring in the mortgage points, mortgage broker fees and other charges, the stated APR may be slightly higher than 3.5%.
How is a finance charge calculated?
For finance charges that are expressed as a percentage, the charge is calculated based on the balance owed and the billing cycle length.
For example, let’s say you have $1,000 in credit card debt with an interest rate of 24%.
The interest rate is annual, so to find the monthly charge you would need to divide 24 by 12 — meaning the monthly rate would be 2%.
At the end of the month-long billing cycle, assuming you made no further payments or purchases, the finance charge would be $20, or 2% of $1,000.
Note that this is an overly simplified calculation; there are actually several ways that finance charges are calculated, and each lender differs in their method of choice.
What is a minimum finance charge?
Some lenders may have minimum finance charges. It’s essentially the lowest amount that a lender will charge regardless of the loan balance.
For instance, if a credit card issuer has a minimum finance charge of $5, they may charge you $5 in interest even if you only carried a very small balance.
Reducing finance charges
Finance charges can really add up, which can affect your overall financial wellbeing. How can you reduce these charges?
There are essentially two approaches:
Refinance debt to get a lower interest rate
Pay off debt so that you don’t pay any interest at all
In either case, the goal is to lower the amount you pay in interest to bring down your total finance charge expenses.
If you have credit card debt, consider exploring the services that Tally† offers. Tally is a personal finance app that can help qualifying Americans consolidate their credit card debt to pay down debt more efficiently. Use Tally’s credit card debt calculator to learn how much qualifying borrowers could save.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.