What is a Finance Charge?

A finance charge is kind of like the price of a ticket to a food festival...

Once you’re inside the festival area, you’re going to want to buy some food, but that’s not included in the ticket price. The ticket price only covers the cost of entering and accessing the festival area, not any purchases you make when you’re there. Similarly, a finance charge is the cost of taking out (entering) a loan. What you do when you have the loan is up to you, but you need to pay up just to get access to the funds.

A finance charge is any cost or fee directly associated with borrowing money. Essentially, it’s the cost of borrowing money. It may be charged at the start of a loan, at the end of each billing cycle, when a loan period is extended, or at the end of each day (typically compound interest).

When you borrow money from a lender, you rarely get that money for free. Unless you’re borrowing from a friend or family member, taking advantage of an interest-free financing period, or you’ve found an interest-free balance transfer offer without a balance transfer fee, you’ll almost always need to pay some type of fee when you borrow money.

These fees incentivize lenders to make loans. Giving out a loan is risky — There’s no guarantee that the borrower will ever pay it back. Without finance charges, there would be no reason for a lender to give loans outside of kindness and goodwill. Think of finance charges as the cost of the lender’s services.

One of the most common finance charges is interest, a recurring charge that is typically calculated as a percentage of the principal amount (the amount of the loan). Interest can either be compounding (interest gets charged on unpaid interest) or non-compounding (interest is only charged on the principal).

However, there are other types of finance charges as well. For example, when taking out a mortgage loan, borrowers may need to pay loan origination fees (the fee to start the loan). When taking out a cash advance, borrowers may need to pay a cash advance fee. Typically, both of these are calculated as a percentage of the loan amount. But some finance charges can be flat fees that are independent of the loan amount — i.e., a set $10 fee for borrowing money, no matter how much you borrow.

The finance charge for a loan is often expressed as the annual percentage rate (APR), which refers to the yearly cost of interest (and sometimes fees) for a loan. However, a loan’s APR doesn’t give the full picture of the finance charge, as it doesn’t include compound interest costs. Additionally, it doesn’t always include fees, and it only expresses these charges yearly, not for the lifetime of the loan.

The annual percentage yield (APY) is a bit more accurate as it takes compounding interest into account. But again, it only refers to the costs for a single year and may not take fees into account.

Credit cards provide revolving credit: There is no set date that the balance must be paid off by, and it will keep accruing finance charges until it hits zero.

Most credit card finance charges are calculated using a method called the average daily balance. It’s also referred to as straight average daily balance and true actuarial average daily balance. In this method, finance charges are calculated based on your balance at the end of each day. At the end of the billing cycle, the credit card provider will find the average of your daily balances and use this to determine your finance charges.

For example, imagine you start the billing cycle on June 1 with a $500 credit card balance on a card with an 18% APR. On June 7, you make a $30 purchase, bringing your balance to $530. On the 12th, you make another $50 purchase (balance of $580). On the 20th, you make another $30 purchase (balance of $610). At the end of the billing cycle, your balance is $610.

The credit card provider will add up the daily balances, like so:

Next, the credit card provider will average these costs over the number of days in the billing cycle (30 days):

$17,000/30 = $566.67

Then, the credit card provider will multiply this amount by the monthly interest rate (APR divided by 12) expressed as a decimal:

0.18/12 = 0.015

$566.67 * 0.015 = $8.50

So, at the end of this billing cycle, you’d need to pay $8.50 in interest. If you extend the balance into the next month, you would repeat this calculation either with a starting balance of $610 or $618.50 (if your credit card provider doesn’t require minimum payments).

Although this is the most common method of calculating credit card finance charges, every credit card is different. Some offer grace periods (a set period of time after you borrow money) during which you can pay off the balance without incurring any fees. Other methods of calculating credit card finance charges include:

• Two-Cycle Average Daily Balance (calculates daily average over two billing cycles)
• Ending Balance Method (deducts payments and credits before applying interest)
• Previous Balance Method (uses previous cycle’s balance before purchases or payments)
• Adjusted Balance Method (payments are subtracted from the last cycle’s balance, purchases are added after the interest is calculated)

Finance charges for closed-end (term) loans — loans with a predetermined amount and payment schedule — are based on the annual percentage rate (APR) plus any fees. This gives you the amount of non-compounding interest you’ll pay each year. The APR may also include fees, but not always. When it doesn’t, you’ll add the fees, which vary from loan to loan, onto the APR.

To calculate your total interest paid, you can simply subtract your loan amount (principal) from your total payments (monthly payment * number of payments).

For example, if you have a five-year car loan (60 months) for a $15,000 car with a monthly payment of $300, the total cost of the loan is $18,000 (60 * $300). Now, subtract the amount you borrowed ($15,000) from the total cost ($18,000) to get the cost of the interest, $3,000 ($18,000 – $15,000). If there are no other fees, this is your finance charge.

If there are other fees, such as a 1% origination fee, add this to get your finance charge. On the same loan, a 1% origination fee would be $150 ($15,000 * 0.01), so your total finance charge would be $3,150 ($3,000 + $150).

Finance charges are calculated differently depending on the type of loan or credit card product.

To get the most complete and accurate picture of the finance charges for a loan, you can make an amortization schedule (a list of all loan payments). Once you’ve added the loan payments, add on any additional fees, then subtract the principal (the original loan amount) to figure your total finance charges.

For revolving credit, such as credit cards, the finance charge is typically calculated using the average daily balance method. In this method, finance charges are calculated based on your balance at the end of each day. At the end of the billing cycle, the credit card provider will calculate your average daily balance and multiply this number by the interest rate. The resulting amount will be added to your balance. If you don’t pay off your balance at the end of your billing cycle, you will be paying interest on that added interest the following month.

A finance charge refers to the cost of borrowing money in the local currency, i.e. U.S. dollars in the United States. This includes any fees attached to the loan in addition to the interest.

Interest can be a part of a finance charge, but you can have a finance charge without interest, such as a one-time loan origination fee (this is not common, but theoretically possible).

In short, interest (when expressed as a dollar amount) is a finance charge, but a finance charge doesn’t always include interest.

Finance charges can’t always be avoided. In a mortgage loan, for example, there is often a fixed amount of interest that must be paid over the course of the loan. This can’t be avoided.

However, when finance charges can be avoided — i.e., when a credit card offers a grace period (a period of time in which interest is not charged) — you’ll avoid them by paying your balance ASAP. Even if you can’t avoid them altogether, this can reduce the fees.