What is a Finance Charge?
They say if you want a free loan, find a secret rich uncle you never knew about before.
Maybe people don’t actually say that, but they should start. Because almost any loan you take out, unless it’s from an understanding friend or family member, is going to cost you some form of payment.
If you find yourself borrowing from a more formal resource -- like a bank or other type of lender -- the cost is likely to originate in the form of a finance charge.
What is a finance charge?
A finance charge is a general description of a cost associated with a loan.
A finance charge is essentially any amount you have to pay the lender beyond the amount you borrow (the amount you borrow is also referred to as the principal). These additional costs are charged by the lender, both for profit and to cover the cost of processing the loan. Some loans might allow you to avoid a finance charge, while others will not be so flexible.
Finance charges may also include interest charges, though some lenders may separate interest from other costs of borrowing.
Types of finance charges
There are many types of loans -- which means there are many types of finance charges.
Not all loans are structured the same, so it can be difficult for a borrower to compare loans from different lenders. That’s why the Truth In Lending Act requires lenders to disclose standardized information, including APR -- or annual percentage rate -- and total cost to borrowers.
APR is a number that shows the total amount of finance charges -- whether they show up as interest or an upfront cost -- and is presented as a percent of the amount that was borrowed. Although it isn’t always a perfect measure, it can better allow you to compare different loans to figure out the most affordable way of borrowing money.
Since there are many types of loans, it doesn’t make sense to only talk about finance charges in the abstract. Instead, let’s look at some different kinds of loans and the finance charges associated with them.
Credit card finance charges
Wait, credit cards are loans? Technically, yes.
A credit card is a revolving line of credit, which is a type of loan that allows you to borrow a certain amount of money under a given limit. If you want to borrow more money, you have to pay back a portion of the money you’ve already borrowed. Here are some finance charges you may see if using a credit card.
Some credit cards charge an annual fee. Annual fee cards tend to either be for users who couldn’t otherwise qualify for a credit card, or on the other end of the financial spectrum, for users who want more rewards, perks, and cashback opportunities. These fees tend to range from the tens to the hundreds of dollars each year.
Other credit cards may allow you to avoid finance charges entirely. Most credit cards come with a grace period on new transactions before they start to charge interest on purchases. As long as you pay off your entire credit card balance before the due date each billing cycle, you won’t have to worry about accruing interest-related finance charges.
On the other hand, if you only make the minimum payment -- the least amount of money you have to pay -- on your balance each month, interest will accumulate on the remaining balance. If you never pay off your balance entirely, you could find your monthly payment rising as the amount of interest you owe -- and the amount of money you owe, overall -- grows. Additionally, if you make a late payment, you may face late fees.
Once you start to rack up credit card debt, it can be difficult to turn your situation around as your credit card bill continues to grow. If you find yourself in this situation, consider a repayment plan that prioritizes your credit cards.
Credit card offers
Some credit card companies have special limited-time 0% APR offers. If you qualify for one of these cards, performing a balance transfer from a credit card with a higher interest rate to the new no-interest-rate credit card could aid in paying off the old debt. However, there are some considerations to keep in mind:
- Can you pay off the new card before the offer ends? If so, you might be able to get out from under your old finance charges. However, if you can’t pay off the balance in time, you may find yourself taking on new finance charges -- such as the total amount of interest you would have accrued without the offer rate.
- Is there a fee to transfer over a balance from a different card? Some credit card companies charge a balance transfer fee, which can be a percentage of the amount you are moving to the new card.
With this in mind, be sure to do your research so you don’t end up in a more expensive situation with a different credit card issuer. Of course, the best plan of action is to never carry over a balance on any credit card from month to month. Paying off your balance in full each month will also reflect well on your credit score.
Payday loans are short-term, high-APR loans that must be paid back in a certain number of days. Unlike many other loans where interest accumulates over the life of the loan, payday loans tend to require a flat fee, even if you could pay off the loan before the term ends. If a payday loan borrower cannot pay their loan back by the due date, then they must extend it or roll it over -- while taking on additional fees to do so.
If a borrower cannot pay the loan after one extension, the cycle will repeat until the borrower pays off the full dollar amount. It can be an endless cycle of recurring fees that cumulate, which can have devastating impacts on the borrower.
Payday lenders are often considered riskier than other financial institutions and are often used by borrowers who need a personal loan but can’t qualify for traditional consumer credit or financial services.
Cash advance loans
Technically, a cash advance is a loan taken out by using a credit card at an ATM. In addition to whatever transaction fees the ATM may carry, cash advances tend to have higher interest rates than regular credit card transactions, and they don’t come with a grace period. (Translation: Interest will accrue immediately if there is a balance that remains after the due date.)
Many payday lenders will also refer to their product as a “cash advance.” If you’re considering a cash advance that you don’t acquire by using your credit card at an ATM, then that is probably a payday loan and will come with a similar finance charge structure as one.
Generally, an installment loan is a personal loan that a borrower pays off in installments over a relatively long period of time. Ideally, installment loans are amortized, which means that each payment covers a portion of the interest and other finance charges as well as the principal, so even if you're only making the required payments, the entire loan will be paid off in a predetermined amount of time.
There are personal installment loans for general purposes as well as more specific types of installment loans, such as mortgages, auto loans, and student loans. Each of these loan types comes with its own form of finance charges. Mortgages, for example, tend to have origination fees, discount points, insurance requirements (to protect the lender if they believe there is a risk of default), and more. In fact, mortgages are one of the more complex types of loans, deserving of an entire article of their own.
To finance or not to finance
While it often isn’t possible to avoid finance charges entirely, your personal finances could be improved if you find ways to minimize them. You can’t always avoid borrowing money, but you can do your best to pay less to do so.