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What Is A Finance Charge?

9-minute readJune 05, 2021

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Taking out a loan or line of credit is a big financial move and with it comes certain financial obligations. It’s important to understand these obligations, usually spelled out in the terms of the loan, so you can make an educated decision on whether you should borrow money and can afford to. One common obligation is paying a finance charge. Finance charges come in a variety of forms and, when borrowing money, it is important to know what type, or types, you’ll need to pay. Before we get into that, let’s explore what a finance charge is exactly.

Finance Charge Definition

A finance charge is a fee incurred for borrowing money from a lender or creditor. This is how lenders are able to make a profit and lessen the risk of lending. Without a finance charge, borrowers may be less apt to pay down or pay back their loans. A finance charge can be a flat fee or percentage of the borrowed amount.

How much you’ll pay will depend on your lender, the type of loan you have, the amount you borrow and the type of finance charge that comes with the loan.

Types of Finance Charges

No matter what type of loan you consider, chances are that you’ll have some sort of finance charge. Here are the types you’ll most likely encounter.

Interest Rates

Interest rate is a percentage of the principal loan balance that the lender charges that’s added to your monthly payment. Interest rates can be fixed, in which they stay the same for the life of the loan, or adjustable, in which they change periodically. There are a number of factors that go into determining your interest rate on a loan or line of credit. There is a base rate, or index, which is usually determined by the U.S. Prime Rate or London Interbank Offered Rate (LIBOR). In 2021, the Secured Overnight Financing Rate (SOFR) will be used instead of LIBOR.

From there, several factors play a role, including the lender’s policies and your credit score and credit history. For mortgages and car loans, your down payment and the loan term also affect the rate. For mortgages, specifically, it will also depend on the type of loan you get and the location of your home. For auto loans, the age of the car you purchase may impact your interest rate as well.

 

Annual Percentage Rates (APRs)

An APR is the yearly cost to borrow money from a lending institution. The APR is the index plus a margin charged by the lender. For a mortgage, it also includes the total amount of interest charged on the loan combined with all other fees.

When it comes to APRs for credit cards, there are a few different kinds, which are based on how you use your line of credit.

Purchase APR is applied to purchases you make with your credit card. If you pay your bill in full every month, you will not be charged interest. The time between billing cycles, when you are not charged interest, is like a grace period. It gives you the ability to pay back the borrowed amount without an interest charge. At the end of the billing cycle, you’re only charged interest on the amount of money that’s not paid back. 

Cash Advance APR is applied to any cash you borrow against your credit limit. A cash advance is different from a purchase because you’re using your credit card to withdraw actual money like you would a debit card. However, instead of pulling money from a bank account, you’re pulling it from your credit line. Interest on cash advances is charged immediately, with no grace period like a purchase APR. A cash advance APR is also typically one of the highest types of APRs.

Penalty APR is used when you break one of the terms of your loan, like making a late payment. It usually increases your purchase APR, which you will pay until you are able to make consecutive, on-time, minimum payments for a specified amount of time.

Introductory APR is a promotional interest rate that is used to entice new borrowers. That’s because an introductory APR is typically very low or even 0%. At 0%, you would not pay any interest on your purchases – or balance transfers, sometimes – regardless if there is an unpaid amount left at the end of the billing cycle. Introductory APRs only last for a certain amount of time, usually up to a year. Once the introductory period is over, you’ll have a new APR. Moving forward, you’ll need to pay that APR on any remaining balances you have. It’s important to know that if you break any terms (like if you make a payment late), your introductory period could end early. Remember, too, that some credit card companies will charge you the differed interest if you have a balance on the card when the introductory period ends. Make sure you read and understand the terms before you apply.

Balance Transfer APR is applied when you transfer a balance from one credit card to another. Just like the cash advance, a balance transfer is charged interest immediately and doesn’t have a grace period.

Origination Fees

An origination fee is charged by the lender to process your loan. It’s an upfront fee that is typically between 0.5 – 1% of your loan. Origination fees are common on mortgages, personal loans, auto loans and student loans. They’re not typically applied to credit cards but can be applied to certain lines of credit, like a Home Equity Line Of Credit (HELOC).

Late Fees

As the name implies, late fees are charges that you incur when you fail to make your payment by your due date. While you can be charged a late fee every time you make a late payment, you can only be charged one late fee per billing cycle. There is also a maximum amount you can be charged each time. You can avoid this fee entirely by making your payments on time every time.

Closing Costs

One type of finance charge you’ll see specifically on mortgages is closing costs. These are the fees you pay to close on your home. They include a number of different costs, including your down payment, underwriting fees, title search, appraisal fees and mortgage discount points, if you have any. You typically pay closing costs on the day you close on your new home, the last part of the home buying process.

Prepayment Penalties

A prepayment penalty is a fee some lenders may charge a borrower for paying a loan off earlier than scheduled. This helps prevent lenders from losing any income they would make from interest. Not all lenders will do this. A prepayment clause must be included in the loan contract. Note that prepayment penalties are more up to the lender’s discretion than reliant on the type of loan.

       

 

What Can Finance Charges Be Assessed On?

Finance charges are the costs of borrowing money, so they are assessed on lines of credits and loans, which you use to borrow money. Not all loans, nor lenders, are the same and each may charge different types of fees and have different rates. For example, mortgages, student loans and personal loans usually have interest rates below 10%, while the average interest rate for a credit card is 15 – 19%. Mortgages also include closing costs and origination fees, while credit cards do not.

Let’s take a look at the most common types of loans and the kinds of finance charges you can expect to find on each.

Credit Cards

Credit cards allow you to borrow money against a line of credit up to a maximum amount. They provide quick access to funds, allowing you to make a purchase with just a swipe of the card. Your line of credit is revolving, meaning as long as you stay within your credit limit, you can use your credit card as often as you like. As you pay off your balance, more credit (within your limit) becomes available. The typical finance charges for credit cards include:

  • Interest applied to the balance owed at the end of a billing cycle
  • APRs (APRs vary depending on how you use your card)
  • Late fees

Mortgages

Mortgages are loans that are used to purchase a home or gain access to the equity in your home through a refinance or HELOC. The types of finance charges common for mortgages include:

  • Closing costs
  • Origination fees
  • Interest applied to remaining loan balance each month
  • APR
  • Late fees

Auto Loans

As the name implies, auto loans are used to purchase a new or used vehicle. The money is taken out in one lump sum for one purpose (buying a car) and then paid back over time with interest. Here are the finance charges you can expect to find on an auto loan:

  • Origination fees
  • Interest applied to remaining loan balance each month
  • APR
  • Late fees

Student Loans

Student loans help college students fund their education, including room and board. Student loans can also be used to pay for other necessities when it comes to higher education, including textbooks and supplies, lab fees, internet services and more. There are federal and private student loans. Federal loans are funded by the government and tend to have lower interest rates. Private student loans are funded by a lender and may have higher interest rates. Typical finance charges applied to student loans are:

  • Interest applied to remaining loan balance each month (depending on your loan, interest may accrue while you’re still in school)
  • APR
  • Late fees

Personal Loans

Unlike a mortgage, auto loan or student loan, which each have a very specific funding purpose, a personal loan is delivered in a lump sum that can be used for almost any reason, including consolidating debt, purchasing a car, paying for your wedding or making home improvements. The most common finance charges you’ll find on these types of loans are:

  • Origination fees
  • Interest applied to remaining loan balance each month
  • APR
  • Late fees

Are Finance Charges Avoidable?

The answer to the question of whether finance charges are avoidable is yes … and no. While you may be able to avoid some finance charges, others are unavoidable. However, that doesn’t necessarily mean you can’t lower some of those expenses. Here are a few ways to avoid or lower certain finance charges.

Avoid late fees and penalty APRs by making your payments on time and paying at least the minimum amount. These charges are easily avoidable. To help ensure you make on-time payments, consider enrolling in auto-payments, which automatically withdraw a specified amount of money from your account on a specific date to pay your monthly bill. You can also put your due date in the calendar on your phone and set a reminder alarm. You’ll also want to make sure you include your minimum payment in your budget to ensure you have the funds available to make the payment.

Pay off credit card balances in full before the end of your billing cycle. You only pay interest on the unpaid balance at the end of your billing cycle. If you pay that amount in full before then, you won’t have an unpaid balance and therefore will void an interest charge that month. Credit cards have a grace period from the time a new billing cycle starts until it ends. During this time, you aren’t charged interest on the balance you have.

Improve your credit score and practice responsible borrowing. Remember, better credit scores and good credit histories are often rewarded with better rates and terms.

Shop around for lower rates and fees. Not all finances charges are the same among the various lenders. Contact different lenders and compare their charges, rates and terms before deciding on one.

Put more money down. A larger down payment reduces the lender’s risk for lending to you, which can help you get a lower interest rate.

The Bottom Line

Lending is a business, and while lenders are happy to loan money to qualified individuals, they won’t do it for free. That’s where finance charges come in. Finance charges are the costs associated with borrowing money. While some can be avoided, others cannot. To find lower finance charges on your loans, shop around, be a responsible borrower and read and understand the terms of the loans. Remaining educated and up-to-date on finance topics, like borrowing, home buying and using credit can help too. Get help becoming an informed borrower by checking out more credit articles at Rocket HQSM.

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Rocket HQSM has partnered with CardRatings for our coverage of credit card products. Rocket HQ and CardRatings may receive a commission from card issuers. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities.

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