What is a Finance Charge?
The term “finance charge” refers to the fee charged by a lender or creditor for extending a loan or credit to a borrower. It is either charged as a flat fee or in terms of the percentage of the borrowed fund, with the latter being the most common practice. Besides the interest charges charged by the lender, a finance charge also includes various other costs, such as the cost of carrying the debt, account maintenance fees, transaction fees, late fees, etc.
Example of Finance Charge (With Excel Template)
Let us take a look at the following examples to understand the concept of the finance charge.
Let us assume David charged $1,000 on his credit card during April 2021, and he could only manage to pay back $500 by the due date. Thus, his credit card obligation stood at $500 after the due date. Next month, he neither used his credit card nor made any payments, which means his average daily balance remained at $500, so he had to pay a finance charge on that amount.
After the end of the next billing cycle, the credit card company calculated the finance charges based on the balance amount, APR, and the number of days in the billing cycle. For example, if the APR is 18% and the billing cycle has 21 days, determine David’s finance charges.
Given, Balance amount = $500
APR = 18%
No. of days in billing cycle = 21
Now, the finance charges can be calculated as shown below,
Finance charges = Balance amount * APR * (No. of days in billing cycle / 365)
= $500 * 18% * (21 / 365)
Therefore, David had to pay finance charges of $5.18 to the lender.
Let us take the example of Joe, who availed of a 30-year mortgage loan of $500,000 to purchase his new apartment. If the mortgage loan carried an APR of 8%, determine the finance charges to be paid by Joe over the course of the loan.
Given, Amount = $500,000
APR = 8%
No. of months = 30 * 12 = 360
Now, the monthly payment for the loan can be calculated as shown below,
Monthly payment = Amount * (APR/12) * ((1 + APR/12)No. of months) / (((1 + APR/12)No. of months) – 1)
= $500,000 * (8%/12) * ((1 + 8%/12)360) / (((1 + 8%/12)360) – 1)
Now, the finance charges to be Joe can be calculated as shown below,
Finance charges = Monthly payment * No. of months – Amount
= $3,669 * 360 – $500,000
Thus, Joe has to finance charges of $820,776 over the course of the 30-year mortgage loan.
Regulations of Finance Charge
The following regulations govern the finance charges:
- As per the Truth in Lending Act, the lenders are mandated to disclose all types of fees being charged to the consumer. The fees primarily include standard fees, interest rates, and penalty fees.
- As per the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009, the lenders should offer a minimum grace period of 21 days before they start charging interest on new purchases.
How to Save money on Finance Charges?
In example 2, it can be seen that the finance charges paid over a long term eventually add up to exceed the actual borrowed money. So, an important question can be – “Is there any way to save money on these finance charges?” The answer is “Yes.”
In the case of mortgage loans or any other loans, the borrowers can save a lot of money on finance charges by making extra payments (more than the scheduled monthly payments) every month. For instance, if Joe makes a mortgage payment of $4,000 per month in place of $3,669, then he can save up to ~$242,000, while the loan would be paid off in less than 23 years. So, it can be seen that the extra payments save on the amount of finance charges and result in paying off the loan much earlier than scheduled.
Avoiding Finance Charge
Avoidance of finance charges is generally associated with credit card payments. Basically, a credit cardholder needs to pay finance charges for carrying a balance (as seen in example 1), and thus finance charges can be avoided by paying the full balance every month. In other words, to avoid finance charges, the payment should be made within the grace period, which is usually in the range of 21 to 25 days. In case only a part of the balance is paid, then the finance charges will be added to the next billing statement on the basis of the unpaid balance and any new purchase.
Some of the key takeaways of the article are:
- Finance charges include all types of costs incurred by a borrower for availing of any kind of credit. It can be defined as any amount that a borrower has to pay to the lender over and above the actual borrowed money.
- It is either charged in terms of percentage of the borrowed money, such as interest rate, or as a flat fee, such as transaction fees.
- Consumers availing of long-term loans can make significant savings on finance charges by making extra payments to reduce the outstanding balance at a faster rate, which reduces the interest being charged.
- The Truth governs the finance charges in the Lending Act and the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009.
Although finance charges are expenses for a borrower, it also results in the borrower having liquidity at his disposal in exchange for a particular amount of money. Further, there are ways to avoid and also save on finance charges. Even there are government regulations that ensure that the consumers are not exploited.
This is a guide to Finance Charge. Here we discuss the definition, regulations, and how to Save money on Finance Charges, along with practical examples and downloadable excel templates. You may also look at the following articles to learn more –