A finance charge is the cost of borrowing money. These charges come in all shapes and sizes, and at times, it can be difficult to understand what you’re signing up for. Fees can easily rack up and lead to financial hardship if left unchecked. Fortunately, understanding how they work is easier than it might seem.
If you’ve ever struggled with understanding finance charges, this post is for you. Together, we will explore different finance charges, when they apply, and how you can avoid or reduce them.
What are finance charges?
A finance charge is a fee charged to a borrower by financial institutions or lenders. When borrowing money, you’ll need to pay several fees to cover the costs assumed by the lender. In addition, a lender needs to make a profit from lending money or there wouldn’t be a motivation to do so. Lending money is risky, so the lender needs to make sure it is worth their time.
Finance charges come in all shapes and sizes and depend on several factors, including:
- How much money you’re borrowing
- How you’re borrowing the money
- Your Risk
- Other Costs
Understanding these factors is essential before you borrow.
How much money are you borrowing?
The lender must account for the lump sum of money you’re borrowing. Generally, the bigger the amount, the bigger the risk and the higher the costs. The ratio only works up to a certain point before economies of scale kick in (typically).
How are you borrowing the money?
This refers to the service and the terms & conditions under which you’re borrowing the cash.
Loans, credit cards, and mortgages are all types of money borrowing. Since these all have distinct features, different charges will apply.
Are you high or low risk?
Lending someone money is risky. There is always a chance they will not pay the money back, and this risk is reflected in fees. As a rule of thumb, the bigger the risk – the bigger the fees.
The higher the risk, the sooner the lender wants to recoup their money at least while ideally making a profit. Risk increases over time and more risk is not something lenders are fond of – unless the lender is compensated for it.
What’s the cost of lending?
There are several costs associated with lending money.
Administrative costs are one thing that quickly springs to mind, but this cost is minimal when compared with other costs. Inflation is a much higher cost, as is the opportunity cost.
An opportunity cost refers to the cost when choosing one option over another.
To illustrate this with an example, when a lender lends a borrower money, they cannot do anything with that money until the borrower pays it back. Instead of lending out that money, the lender could have invested it in stocks, flipped a house, opened a business, or a million other things.
The opportunity cost is the profit the lender would have made had they decided to pursue something else instead of lending out that money.
Types of finance charges
Interest, charged as an APR (Annual Percentage Rate), is generally the most significant financing charge. The amount of interest is always calculated and charged as a percentage, payable monthly (in most cases) for the entire duration of the term.
Interest is charged as a percentage of the money owed. The interest payments in real dollars are higher at the beginning of the term than towards the end.
Typically, the applicable interest rate depends on many factors, including your credit score, which the lender gets from your credit report.
An annual fee is charged yearly for every year you use the credit facility. In most cases, annual fees are flat fees payable at the beginning of the year. The actual amount will vary depending on the type of credit facility.
As mentioned previously, borrowed money is something you’ll always need to pay back. This paying back is usually done monthly on a date agreed by the lender and the borrower. The lender may charge a late payment fee if the borrower misses the date.
A closing fee is a fee charged for closing the deal. In essence, once the lender and borrower agree on all the terms and sign all papers, the lender will take a note of the costs incurred and charge them as a closing fee.
Closing fees are usually a percentage of the loan amount. The premise is that the bigger the loan, the more work needs to go into it (and thus, the buyer incurs more expenses).
An origination fee is like a processing fee, charged upfront to process your loan. The fee is usually a percentage of the total loan amount.
A prepayment charge is a fee charged when paying off the total amount of the loan before the end of the term. While this may sound counterintuitive, do remember that lenders charge an interest rate on money owed.
When borrowers stop owing money to lenders, interest cannot be charged. The lender will not make all of the money they originally planned on making.
Prepayment charges are specific to each lender and who will undoubtedly list them in the loan terms and conditions.
Overdrafts fees are charged whenever you overdraw your account, essentially taking a line of credit. While some banks offer overdraft protection, overdrawing your account typically means paying an overdraft fee.
Overdraft fees are notoriously high, especially when considering your overdrawn amount. You’ll typically pay these flat fees, irrespective of how much money you’ve gone over. That said, this isn’t always the case. This charge can sometimes be a percentage of the money you’ve borrowed.
Speaking of overdrafts, the bank may also charge interest on the outstanding balance not paid within a required number of days, referred to as the grace period.
Balance transfers fees
You pay balance transfer fees when you transfer credit card balance debt from one card to another. While people usually do this to take advantage of a better rate, the fee can dig into those savings.
Transaction charges are a flat fee finance charge applicable when a sum of money is transferred from a credit facility to a bank account.
A good example is foreign transaction fees – a charge for buying something on a credit card in a foreign currency.
Finance charges by credit type
As previously mentioned, different types of credits carry different types of charges. It’s important to note that even though some charges are common for a credit type, it does not mean the lender will charge them.
You’ll see many lenders offering credit facilities without fees. Generally, for the reasons we mentioned above, this does not mean they do not charge ANY fees – but rather, they only charge some of the fees.
Auto loans are for funding purchases of vehicles, with many banks offering different types of loans depending on the type of purchase. While this may affect the amount payable, fees will generally include interest, an origination fee, and late fees.
Mortgages are among the most significant types of loans available for buying real estate, generally running into the hundreds of thousands. As you might expect, these carry numerous charges and are one of the most expensive loans with a long repayment term.
Personal loans are a type of unsecured loan usually used for funding big purchases, consolidating debt, and everything in between. Since this is a competitive space, personal loans don’t carry many types of fees. That said, interest can be relatively high.
Credit card finance charges are charged by credit card issuers to cardholders every billing cycle.
Depending on how much of the available credit you utilize, the credit card bill can be pretty high. Failure to make consecutive payments may also lead to credit card debt.
Line of credit
A line of credit works like a hybrid combining loans and cash advances. While a line of credit limits how much money you can borrow, you do not receive a lump sum but can withdraw it as needed up to the maximum allowed.
How to avoid finance charges
One sure-fire way to avoid paying charges is to shop around. The financial services market is more competitive than ever before. Many banks and lenders are trying to undercut the competition to attract new customers.
They do this by offering lower or no fees at all. Banks and credit card companies may also offer other incentives such as bonuses and perks to reduce the overall cost of obtaining credit.
Read the terms and conditions
It’s essential always to read the terms and conditions. Doing so will help you understand what charges become applicable when.
Equally, it’s also important to avoid making just the minimum payment required since this can rack up charges such as interest.
Pay on time
You’ll typically need to pay late fees when you haven’t made payment by the due date. The money may also rack up interest, making late payments even more expensive.
Limit your borrowing
The more money you borrow, the lower your credit score will be. People with a low credit score will get less favorable terms, including higher interest rates which can exacerbate the problem.
Frequently Asked Questions
What does a finance charge do?
With different costs related to lending someone money, lenders charge various finance fees to cover their costs while making a profit.
What is a finance charge on loan?
Loans carry several finance charges, including interest, origination, closing, and late fees.
What is an example of a finance charge?
Interest is an example of a finance charge. It’s directly related to the amount of money borrowed, the borrowing period, and any associated risks.
Most interest charges are given as a band with the applicable rate depending on several factors, including your credit score.
Do I have to pay a finance charge?
All finance charges need to be paid by the due date (usually in monthly payments).
You can avoid paying certain finance charges by being diligent in your approach to finances. Make sure you shop around for the best offers and make all your payments on time.