What Is a Finance Charge?

It might seem like a windfall when you get a new credit card or take out a new loan. Suddenly, you’ve got some breathing room with your money! You can exhale.

But that breath comes with a cost.

Eventually, you’ll have to pay something over and above the credit you’ve used or the amount you’ve borrowed.

It’s called a finance charge.

Understanding Finance Charges

We’ve looked for it pretty much everywhere, and, sadly, haven’t found it yet, so we’re starting to suspect something: There’s probably no such thing as free money, at least not from the financial institutions (banks, credit card companies, brokerage firms and the like) that make their riches available to you.

They let you use their loot, but they always charge you for their largesse. And frankly, you can’t really blame them. It’s how they made that money they’re loaning you in the first place.

The trick, from your perspective, is in knowing whether you can afford the fees and interest they want from you in the deal. Are the finance charges fair for your particular financial situation?

As in any other transaction, you’ll want to shop around and compare the costs of doing business with different lenders and creditors.

There are two main types of finance charges.

1. A percentage of the amount you borrow: Generally, this is the interest you’ll pay on your monthly credit card balance or on a large loan such as for a home or a car.
2. Flat fee payments: They can take a number of forms such as an annual fee for a credit card, a maintenance fee for a loan account, a transaction fee for every time you use an ATM to get cash, a finder’s fee, an appraisal fee and others.

Sometimes, a loan or a line of credit comes with a combination of the two. It’s important to know how the finance charges you’re taking on will affect your bottom line, because one of these two types might work better for you than the other.

How Is A Finance Charge Calculated?

Your financial health is the most important factor in a lender’s calculation of what you’ll owe in finance charges for a loan or a line of credit. The institution considering lending money will look at your credit score and your credit history. Generally, it will assess how deserving you are of getting a loan or receiving new credit. The better your creditworthiness, the less you’ll likely pay in interest rates.

Your creditworthiness is determined by the patterns you’ve established in your previous loan or credit card payments. FICO and other credit bureaus use different credit scoring models, but when they come up with a number for your credit score, they all take into account the amount of your debts, the number of credit cards you have, the frequency with which you make payments on your balances, and other related considerations.

The higher your credit score, the better your creditworthiness.

That said, every financial institution has its own terms and conditions for the products and services it offers in the way of loans and credit. So, as you shop around, it isn’t unusual to find dramatically different finance charges from institution to institution on a loan for the same amount.

Credit card companies, too, use a variety of methods to calculate their finance charges, mostly based on how and when they pinpoint the amount of your outstanding balance.

Here are some of the ways your outstanding balance can be used to calculate finance charges:

• Ending balance, which factors in how much you’ve paid and how many new charges you’ve made from the start to finish of a billing cycle.
• Previous balance, which is based solely on what you owe at the start of a billing cycle.
• Adjusted balance, which subtracts any payments you make during a given billing cycle.
• Average daily balance, which adds each day’s balance in a billing cycle and divides that total by the number of days in the cycle. This is the most widely-used way for credit card issuers to determine their finance charges.
• Daily balance, which multiplies each day’s balance by a daily interest rate to get a daily finance charge. Those numbers then are added during the billing cycle to get a total finance charge for the cycle.

The adjusted balance method generally makes for the lowest finance charges, which – go figure — is probably why there aren’t many credit card companies using it.

In most cases, the back of your monthly bill should include information about which method your credit card uses to calculate your finance charges.

Examples of Finance Charges

The interest you’re paying on your credit cards and loans likely commands most of your finance charge attention, and for two good reasons:

• Credit card interest rates are at an all-time high right now, more than 19%, on average, with no end to the increases in sight.
• They bite you in the keister every darn month. Monthly bill after monthly bill after monthly bill after …

But as we mentioned earlier, interest isn’t the only form finance charges take. Fees very often come along as a plus-one with the interest you’ve invited to the finance charge party.

The good news is that the Consumer Financial Protection Bureau (CFPB) regulates what kinds of finance charges you might have to pay. The not-as-good news is that the list the CFPB allows is looooooooooong.

Some of the most common types of finance charges include:

• Interest charges: This is that percentage thing, the number that’s very high right now and seemingly getting higher with every breath we take. Your credit card interest rate, or the interest rate you’re charged on a loan, is a percentage of what you’ve borrowed. It’s the most common kind of finance charge.
• Premiums or other charges: A creditor can impose a premium charge as insurance for protection against the possibility you might default on the loan, or for protection against loss of or damage to property a creditor is underwriting for you.
• Carrying charges: When you’re paying for something in installments (making regular small payments), the seller or lender can add an extra charge for insurance or storage or interest on the balance until it’s paid off. It’s the cost to the lender of carrying your investment.
• Transaction fees: Because it costs a credit or debit card company a nominal amount every time it processes one of your purchases or ATM withdrawals, it passes that cost along to you. You get nicked every time you make one of those transactions.
• Appraisal fees: The most common form of an appraisal fee rears its head when you’re borrowing money to buy a home. Someone is hired to evaluate independently how much the home is worth, which is something both you and the lender will want to know before you buy it. But you’re the one who pays for the appraisal.
• Finder’s fees: Need someone to locate something you want to buy, or a buyer for something you want to sell? An investment you want to make? When that person gets involved, you pay a finance charge, usually in the form of a commission for his or her services.
• Activity fees: Say you need to transfer funds from one account to another, or maybe you’ve allowed your checking account balance to fall below the minimum your bank or credit union allows. The bank can charge an activity fee every time you need to initiate a specific action. In some cases, ATM withdrawals are subject to activity fees, similar to transaction fees.
• Service fees: This is an amount automatically added to a bill for work or a service performed, like when a restaurant charges a service fee in lieu of expecting you to tip your waiter. In banking terms, service charges are imposed for things such as monthly account maintenance, ATM fees, or foreign transaction fees.
• Loan origination fees: ‘Loan origination’ is sort of a high-falutin’ way to describe the process of taking out a new loan or establishing a new account with a bank or a broker or any other kind of lender. You get charged for the processing costs. Loan origination fees are usually a set amount.
• Account management fees: Somebody at the bank or investment company is watching your money, right? Making sure it’s safe, and there when you need it? A management fee is what you pay to compensate whoever manages your moola or administers the action you want to take with it.
• Late fees: When your payments are overdue, a late fee is the extra amount of money added to what you already owe. It’s a penalty for your failure to meet your obligation. When you don’t pay the bill on time, the bill gets bigger.

Finance Charges and Regulation

As we mentioned earlier, the Consumer Financial Protection Bureau tries to have your back when it comes to finance charges. There are plenty of kinds of finance charges the CFPB authorizes, but there are also fees it doesn’t allow. For example, a housing lender can’t charge you a fee to pay your mortgage over the phone or online. Nor can a bank charge you for whatever research it does or time it spends to answer your specific question about your own account.

The protections in place are a result of the Truth in Lending Act (TILA) of 1968, which requires lenders to make their credit terms readily available to consumers in an easily understood manner. TILA stipulates that a lender must provide a disclosure statement about its loans that, among other things, includes finance charges such as application fees, late charges and prepayment penalties.

Very similar to the Truth in Lending Act is Regulation Z, a Federal Reserve Board rule that essentially implemented TILA in 1969. Regulation Z requires lenders to spell out precise terms of its loans or credit in writing, including the amount of money being loaned, the interest rate at which it’s being loaned, all finance charges associated with the loan, and the length of the loan.

In other words, whatever fees a bank or credit card company imposes must be disclosed to you in advance. Those disclosures sometimes get buried in the fine print, though, so a close reading of your bills and loan agreements can be worth the time and effort.

How to Avoid Spending Money on Finance Charges

You can’t stop ‘em. You can only hope to contain ‘em.

You’ve likely heard that phrase before, usually about a sports team or superstar athlete – say, Patrick Mahomes and the Kansas City Chiefs’ offense, just to use a recent example. But it can apply to finance charges, too.

There are ways to contain the damage that finance charges can do to your resources. In some cases, you can even stop ‘em, or at least bypass ‘em temporarily.

Pay Off Your Credit Card Statement in Full

Remember those different ways we itemized earlier for how credit card companies can calculate their finance charges? Every one of them used the amount of your outstanding balance in any given billing cycle to assess the extra charge you’d owe.

So, what if your outstanding balance is zero? There’d be nothing on which to charge interest, right? That probably won’t work if the finance charge is being calculated on the basis of your daily balance or your average daily balance during the billing cycle. But if you’re being charged on the amount of your ending balance or previous balance and you make sure that balance is totally paid off when it comes time to assess the fee … well, sit back and congratulate yourself.

Use a 0% Interest Rate Credit Card

Zero percent credit cards are out there. They exist. To get one will require a balance transfer from one of your existing cards to a card at another credit card company, and there could be transfer fees involved. But once you have a 0% interest rate credit card, you’ll start saving money on finance charges, at least compared to the high interest rate that came with the card from which you transferred the balance.

Two caveats:

1. You’ll probably need a good credit score to qualify for the new card; and
2. That 0% interest rate will only be in effect during an introductory period. It can last for up to 24 months, but usually runs 12-18 months. When it ends, its interest rate could blast off into the stratosphere.

Avoid Cash Advances on a Credit Card

It’s called a credit card cash advance, but it’s really a short-term loan. And what goes hand-in-hand with most short-term loans? That’s right: High interest rates and transaction fees, even when you you’re using your own credit card to get cash at your own bank or your bank’s own ATM.

We know you sometimes need a quick cash fix, and your credit card can provide it. But like we said up top, there’s probably no such thing as free money. You can take the “probably” out of that last sentence when it comes to a cash advance on a credit card.

Make Extra Payments on Principal Loan Amounts

It’s asking a lot, we know. But if you can swing it, you can get out from under some of the finance charge burden that comes with a mortgage or auto loan by paying more than you owe every month. The finance charge on those loans is tied to the amount of your outstanding balance. If you can reduce that balance more quickly than the loan terms require, you’ll also reduce the amount of interest you’ll be charged going forward.

In a perfect world, paying off your mortgage early would save you a bundle of bucks in interest payments. But like we said, it’s asking a lot. It only makes sense if you can afford to do it.

Finding Finance Charges on a Bill

This will probably make more sense to you if you have one of your credit card bills in front of you before you read on, so we’ll give you a moment to call up the latest emailed statement or dig out a printed snail-mail bill from the pile on your desk. Go ahead. Find one.

Got it? OK, good. Welcome back!

The first place to look for finance charges is the overview of your month’s activity, usually in a prime, first-page spot under a heading called ‘Account Summary’ that includes the basics such as your previous balance, your payments and credits, your purchases, your new balance, the statement’s closing date and other essentials. In that list, you should also find the total amount you paid in fees and interest during that particular billing cycle.

The next place on your bill that pertains to finance charges is under a heading called ‘Payment Information’ (or something close to that). It will include what your minimum payment is for the current bill, whatever payments are past due, and what the due date is for this payment. Somewhere near the ‘Payment Information’ section (we’re getting close to fine-print territory here), you should find a ‘Late Payment Warning’ that tells you how much you’ll pay in a late fee if you don’t pony up in time. Every credit card company is required to include this warning on every bill.

Now it’s time to move on to the ‘Transactions’ section of the monthly statement, which itemizes your purchases, your payments and any other activity on your account during the billing cycle. That list will include any individual fees you’ve been charged if you used the account for a balance transfer, a cash advance, or any other activity that incurs a fee. This, too, is where you’ll find any charges for things such as service fees or account management fees or transaction fees. Your monthly interest charges, including the interest both on your purchases and on any fees you’ve acquired, will be in that list as well.

Farther into the bowels of the statement, you should find a section that lays out the monthly interest calculation on each type of balance you have on the credit card, such as balance transfers, cash advances and purchases.

And finally, another section itemizes the total interest and fees you’ve paid to this point during the year – a running tally of your annual finance charges!

Make sense? Don’t beat yourself up if it doesn’t. Understanding debt can be a gnarly process for anybody. If you have questions, your billing statement will also include information about how to contact the financial institution that issued the card or the loan. You have every right to ask for an explanation, lodge a complaint, or file a protest.

Get Help With Debt Consolidation

Wait! Don’t put away that bill just yet. There is one more element on your credit card or loan statement that we should highlight. Every bill you get from your financial institution must include information about how to contact a nonprofit credit counseling agency if you’re struggling to make your payments. You might have to squint or put on your specs, but look hard enough and you’ll find a phone number that can be very useful.

Don’t be afraid to make that call when times are tough. Credit counseling is an excellent starting point for finding the right debt-relief solution. One of the options a counselor will discuss with you is a strategy called debt consolidation through which you can lower interest rates and reduce monthly payments.

Consolidating debt can help you get out from under unnecessary finance charges in the future, too. That’s part of the process debt consolidation employs to help you get out of debt faster.

A session with a certified counselor at a nonprofit credit counseling agency is free of charge, and the counselor is required by federal law to offer you the best debt-relief option for your unique financial circumstances. Anyone experiencing problems with credit card or loan debt would benefit from that phone call.

Now if you’ll excuse us, we’re going back to our search for free money. If we find it, you’ll be the first to know.