What is a Finance Charge?
A finance charge is the fee charged to a borrower for the use of credit extended by the lender. Broadly defined, finance charges can include interest, late fees, transaction fees, and maintenance fees and be assessed as a simple, flat fee or based on a percentage of the loan, or some combination of both. The total finance charge for a debt may also include one-time fees such as closing costs or origination fees.
Finance charges are commonly found in mortgages, car loans, credit cards, and other consumer loans. The level of these charges is most often determined by the creditworthiness of the borrower, usually based on credit score.
The most typical finance charge is the interest paid on the loan. Interest rates can vary based on the type of loan product. Because a secured loan is backed by some sort of asset or collateral, it is perceived to have less risk and come with a lower annual percentage rate (APR) than an unsecured loan may offer.
An unsecured loan, such as a credit card, is extended solely on the credit history of the borrower and usually carries a higher APR because the lender must assume more risk if they aren't repaid.
How to Calculate Finance Charge
The calculation of finance charges differs depending on the kind of debt involved. For credit card debt, finance charges are based on the average daily balance on the credit card over the financing period, which calculates interest by taking the balance owed at the end of each day into account.
Different lenders calculate the average daily balance method differently depending on how frequently the interest charges are compounded. If the interest compounds monthly, then a lender's finance charge formula for the average daily balance will look like this:
Average Daily Balance = (A / D) x (I / P)
A = the total daily balances in the billing period
D = the number of days in the billing period
I = annual percentage rate
P = number of billing periods per year (typically 12)
If the interest compounds daily, however, the lender will calculate the finance charge by calculating each day's ending balance and add this interest to the next day's beginning balance. (Note: The ending daily balance takes into account the day's charges, payments, deposits, and withdrawals whether the lender uses daily interest compounding or monthly interest compounding.)
Let's look at an example. Let's say you carry a balance on your Bank XYZ credit card that uses the average daily balance method and charges an 18% APR. The tables below compare how the interest would compound monthly (left table) and how the interest would compound daily (right table).
You can see on the bottom of the left table how monthly compounding generates interest more slowly than daily interest compounding does. In this case, the borrower's credit card balance would generate $12.55 in interest finance charges if the interest compounded monthly versus $12.60 in interest finance charges if the interest compounded daily.
And as you might imagine, the larger the credit card balance, the faster the interest charges accelerate, especially with credit cards that use daily interest compounding.
Truth in Lending Act and Other Finance Charge Regulations
Finance charges assessed by financial services providers are subject to regulation by the federal government. Under the Truth in Lending Act, lenders are required to clearly disclose all interest rates, standard fees, and penalty fees associated with the loan product to the borrower.
In 2009, The Credit Card Accountability, Responsibility and Disclosure Act (CARD) mandated a 21-day grace period from new finance and interest charges after a purchase is made using a credit card. Other laws at the federal, state, and local levels also combat predatory lending practices.