Understanding Finance Charges: What You Need to Know

Understanding Finance Charges: What You Need to Know

by | Jun 12, 2023

What Is a Finance Charge?

Finance charges refer to the costs associated with borrowing money or obtaining credit from a lender. It is the fee or interest that a borrower pays for the use of the lender’s funds or the extension of credit. The charges can vary depending on the type of loan or credit arrangement and the terms agreed upon between the lender and borrower. They are typically expressed as a percentage of the loan amount or credit balance.

How Does a Finance Charge Work?

Understanding the way finance charges work is crucial to manage your finances effectively. This allows you to evaluate any borrowing costs and plan your repayments properly.

Finance charges are designed to allow the lender to make a profit on the use of their money and serve as a form of compensation for providing the funds or extending credit to a borrower. There is no set cost when it comes to finance charges, they vary depending on the type of credit product.

Credit cards often have variable interest rates and finance charges that change based on the outstanding balance, whereas loans with fixed interest have finance charges calculated based on the initial loan amount.

Types of Finance Charges

Finance charges come in various forms; however, all are required to be disclosed to you prior to being charged with the fee. While there are various types, listed below are a few of the most common finance charges:

Interest Fees

Interest may be one of the most frequently occurring finance charges. Home or vehicle financing will often carry a lower interest rate than a credit card, due to the lower risk of loans backed by assets.

Carrying Fees

Carrying charges, a charge relating to interest fees, refer to the cost or interest charges associated with a balance on a credit card account or a loan. It is the expense incurred for maintaining a balance over a period of time.

Transaction Fees

If you exceed the maximum allowable monthly number of transactions in a bank or credit union account, you will be charged a transaction fee. Certain accounts have certain limits, so be sure to check your account prior to exceeding your limit to prevent additional costs.

Appraisal Fees

Appraisal fees are the cost paid to an appraiser to assess the value of a property. When buying or refinancing a home, it is typically required in order to ensure the property value is concurrent with the loan amount.

Appraisal fees are not solely considered a finance charge. These fees are typically a one-time charge when obtaining a real estate appraisal. They are an essential cost associated with the real estate appraisal process when obtaining a mortgage loan.

Annual Fees

Some credit cards or lines of credit may have an annual fee associated with them. This fee is charged by the lender for the privilege of having access to credit throughout the year.

Late Payment Fees

If a borrower fails to make a payment on time, lenders may charge late payment fees. These charges are intended to discourage late payments and compensate the lender for the additional administrative costs and increased risk associated with delinquencies.

How Do You Avoid Finance Charges?

In order to avoid finance charges and minimize their impact on your financial health, there are a few strategies you may consider:

1. Budget and Properly Plan

By creating a realistic budget and planning for upcoming expenses, you may prevent incurring finance charges and relying on credit. Setting aside money for planned purchases can help you avoid the need for borrowing.

2. Pay Your Credit Card Balance in Full and on Time

To help avoid paying interest, routinely pay off the entire balance on your credit card. Interest is often only charged on the balance that has not been paid in full.

3. Consider Alternative Financing Options

Explore options such as personal loans or peer lending platforms that may offer lower interest rates than credit cards. By using alternatives, you may reduce the finance charges associated with borrowing.

4. Choose Credit Cards with No Annual Fees

Annual fees can add to the overall cost of using a credit card. It may be best to choose a card that does not charge annual fees in order to minimize unnecessary expenses.

The Importance of Understanding Charges

The Corporate Finance Institute breaks down interest charges due to a mortgage loan:

“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.”

If you experience finance charges, the next step to consider is how to save money while managing these fees. If the finance charge is on a credit card, pay off the full outstanding balance every month. This allows you to avoid any additional interest charges. If you are unable to pay the full amount each month, you can still benefit by paying more than the required minimum per month. This will allow you to save on interest charges while still being within your financial means.

If the finance charges you are dealing with are from a loan, making additional payments on the principal loan amount each month will reduce cost significantly. Not only will this reduce the amount of interest you are charged in the future, but it will also allow you to pay off your loan earlier than expected.

Bottom Line and How to Stay Protected

Finance charges are an additional expense for making a purchase – you are simply paying the lender for borrowing money. Having a thorough understanding of financial charges will allow you to properly navigate the world of borrowing and credit.

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