What is a Finance Charge?
A finance charge refers to any cost related to borrowing money, obtaining credit, or paying off loan obligations. It is, in short, the cost that an individual, company, or other entity incurs by borrowing money. Any amount that a borrower needs to pay in addition to paying back the actual money borrowed qualifies as a finance charge.
The most common type of finance charge is the amount of interest charged on the amount of money borrowed. However, finance charges also include any other fees related to borrowing, such as late fees, account maintenance fees, or the annual fee charged for holding a credit card.
- A finance charge refers to any type of cost that is incurred by borrowing money.
- Finance charges exist in the form of a percentage fee, such as annual interest, or as a flat fee, such as a transaction fee or account maintenance fee.
- Consumers with long-term loans – such as an auto loan or mortgage – can significantly reduce the total amount of finance charges in the form of interest by making additional payments to reduce the outstanding balance on the principal loan amount.
Understanding Finance Charges
Banks, credit card companies, and other financial institutions that lend money or extend credit are in business to make a profit. Finance charges are the primary source of income for such business entities. Such charges are assessed against loans, lines of credit, credit cards, and any other type of financing.
Finance charges may be levied as a percentage amount of any outstanding loan balance. The interest charged for borrowing money is most often a percentage of the amount borrowed. The total amount of interest charged on a large, long-term loan – such as a home mortgage – can add up to a considerable amount, even more than the amount of money borrowed.
For example, at the end of a 30-year mortgage loan of $132,000, paid off on schedule, carrying a 7% interest rate, the homeowner will have paid $184,000 in interest charges – more than $50,000 more than the $132,000 principal loan amount.
Other finance charges are assessed as a flat fee. These types of finance charges include things such as annual fees for credit cards, account maintenance fees, late fees charged for making loan or credit card payments past the due date, and account transaction fees. An example of a transaction fee is a fee charged for using an automated teller machine (ATM) that is outside of the bank’s network.
Transaction fees may also be charged for exceeding the maximum allowable monthly number of transactions in a bank or credit union account. For instance, some checking accounts allow the holder only ten free transactions per month. Every transaction over the ten-transaction monthly limit incurs a transaction fee.
Finance charges that may be calculated as a percentage of the loan amount or that may be charged as a flat fee include charges such as loan application fees, loan origination fees, and account setup fees.
The finance charges that a borrower may be subject to depend a great deal on their creditworthiness as determined by the lender. The borrowers’ credit score at the time of financing is usually the primary determinant of the interest rate they will be charged on the money they borrow.
How to Save Money on Finance Charges
As noted in our example of a 30-year mortgage loan above, the finance charges on borrowed money can eventually add up to a sum even greater than the amount of money borrowed. Credit cards with high interest rates can end up costing much more in finance charges than the amount of credit utilized.
So, how can one save money on finance charges? With credit cards, the easiest way to save money is by paying off the full outstanding balance on the customer’s credit card bill each month. By doing that, the borrower avoids interest charges entirely and only need to pay finance charges such as annual fees. If they’re unable to pay the full balance, they can still save a considerable amount in interest charges by at least paying more than the required minimum payment for each month.
Similarly, homeowners with mortgage loans or individuals with auto loans can save a lot of money in finance charges by making extra payments on the principal loan amount with each monthly payment. For example, if their mortgage payment is $850 per month, they can send a payment of $1,000 to your lender each month, designating the extra $150 as an “additional payment to the principal loan amount.”
It not only reduces the outstanding loan balance by more each month – thus, reducing the amount of interest charged in the future – it would also lead to seeing the loan completely paid off much earlier than scheduled.
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
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