What Is A Finance Charge And Why Is It Important?
Miranda Crace5-minute read
PUBLISHED: March 17, 2023
If you’ve ever borrowed money from a bank or used a credit card, you most likely paid some type of finance charge. Lenders use this cost to create a profit, but why is it important for you to know what it consists of?
Let’s take a look at what finance charges are, the costs that are included and the different categories you’ll encounter when borrowing money.
What Is A Finance Charge On A Car Loan?
Simply put, a finance charge is the total cost of borrowing money from a lender. It can be calculated as a fixed rate or a percentage of the loan amount. For an auto loan, a finance charge could include your interest rate, taxes, application fees, prepayment penalties or some combination of all the above. Lenders use finance charges to generate a profit and thereby be able to create loans for future borrowers.
Why Are Finance Charges Important?
Now that you have an idea of what a finance charge is, you might wonder why you should consider this fee when shopping for a loan or mortgage. The main reason is simple: Understanding what’s included in a finance charge will make you a more informed borrower.
If you compared two loans by only considering their interest rate or loan term, you wouldn’t see the full cost of using either option. Instead, by taking the interest rate, terms and fees all into consideration, you can find the most affordable option for your situation.
What Does A Finance Charge Include?
Depending on the type of loan you’re using, finance charges could include a wide range of costs. Below, we’ll look at the fees most likely to be included for a specific financial product.
Before 1968, home buyers didn’t know the exact cost of taking out a mortgage. This changed on May 29, 1968, with the creation of the Truth in Lending Act (TILA).
Today, mortgage lenders are required to disclose their finance charges and how these charges are calculated. Your lender will most likely include the interest rate, application fee, discount points, mortgage insurance and more within your finance charge.
Like mortgages, personal loans come with finance charges. These may include prepaid service costs or additional fees incurred later. More specifically, the cost of using a personal loan can include interest and origination fees as well as late fees and prepayment penalties.
It’s worth noting that not all personal loan lenders use the same finance charges. For instance, one bank may use a 5% origination fee while a credit union may only charge 2% of the loan amount. This is why it’s crucial – before you apply for a loan – to find out how a lender calculates their finance charge.
Similar to a personal loan, a finance charge for an auto loan includes the total amount of interest plus fees. Your lender may include all your fees in the annual percentage rate (APR) to be paid little by little until the loan is paid in full, or they may require you to pay them upfront when you close on the loan.
Keep in mind: With a car loan, there are ways you can reduce the cost of borrowing money. You can make a larger down payment, choose a shorter term or secure a lower interest rate. Any of these options can decrease your finance charge and save you money in the long run.
Installment loans aren’t the only type of financing that uses finance charges. Credit card companies also use this cost, typically in the form of your APR. You can incur a finance charge by doing a balance transfer, getting a cash advance, making a late payment or using your card while traveling abroad.
Fortunately, you can reduce a credit card’s finance charges by simply being careful. For example, you can make regular, on-time payments each month or avoid taking out a cash advance, both of which would likely incur a fee or higher APR.
Common Categories Of Finance Charges
A lender can place numerous costs under the umbrella of a finance charge. The most common ones for a bank, credit union or credit card company are:
- Interest rate or APR: Your lender might use the interest rate or APR to calculate your finance charge. An APR will include both your interest rate and additional fees.
- Origination fees: Lenders charge an origination fee to cover the administrative costs of creating your loan.
- Late fees: If you make a late payment, your lender may charge you a late fee. You can avoid this charge by making your payment during the grace period – the time period before the new billing cycle begins.
- Prepayment penalties: Paying your loan off early can sometimes incur a fee called a prepayment penalty. However, not all lenders have this fee, so it might not be included in your finance charge.
- Closing costs: Mortgages come with a set of expenses called closing costs. These can include application fees, attorney fees, discount points, escrow funds and mortgage insurance premiums.
- Third-party costs: A mortgage’s finance charge can also include costs from third parties such as an appraiser, home inspector, title company or credit reporting agency.
- Carrying charges: This cost is the interest charged on the unpaid balance of your credit card. If you only make the minimum payment each month, you’ll end up having a bigger finance charge.
- Transaction fees: Some types of credit card transactions may incur more fees than others.
- Service fees: Credit card providers sometimes charge their customers a fee for simply using their services.
How To Calculate Finance Charges
You can figure out a finance charge in a few ways. For example, you can ask your lender, use a finance charge calculator or calculate it yourself with one of the two methods below.
For Credit Cards
This formula can be used to calculate a finance charge for a carried balance on a credit card:
Finance Charge = Remaining Balance × (APR ∕ 365) × Number of Days in Billing Cycle
Let’s consider an example. You have a $300 balance on your credit card and an APR of 16%. Your credit card issuer uses a 30-day billing cycle. You would use the following steps to find your finance charge:
- Convert your APR into a decimal. Divide 16 by 100 to get 0.16.
- Now find your daily interest rate by dividing 0.16 by 365. You should get 0.000438.
- Next, multiply your daily interest rate (0.000438) by your unpaid balance ($300). The average daily balance charge is 13 cents.
- Last, multiply your daily charge (13 cents) by the number of days in the billing cycle (30 days). Your total finance charge is $3.94. Your balance for the beginning of the next cycle would be $303.94.
Since personal loans, mortgages and auto loans use installment payments over a specific length of time, you’ll need to use a different formula to calculate your total finance charge:
Total Amount of Finance Charges = Monthly Payment Amount × Number of Payments − Amount Borrowed
Let’s say you get a personal loan for $20,000 with a monthly payment of $424.94 and a 60-month repayment period. You would use the following steps to calculate your finance charge:
- First, multiply your monthly payment amount by your total number of months. For this example, it’d be $424.94 multiplied by 60 to get $25,496.40.
- Then, subtract the loan amount you borrowed. That would look like $25,496.40 minus $20,000, which equals $5,496.40. This is your total cost to borrow.
To recap: A finance charge is the cost a borrower pays for using a mortgage, personal loan, auto loan or credit card. Each loan type or lender can include different fees in their calculation, but TILA provisions require financial institutions to disclose the total dollar amount. By knowing what the finance charge on a loan is, you can better determine how much that option will actually cost.
If you want to learn more about how much a personal loan from Rocket LoansSM will cost, you can apply today to see the rates and terms you qualify for.
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