In a NutshellA finance charge is part of the cost of borrowing money. Different types of debt can come with different types of finance charges. Understanding finance charges can help you pick the best borrowing option for you.
With so many types of credit available, it’s easy to get confused about all the different types of finance charges you can end up paying.
The term “finance charge” has a very broad definition. According to current regulations within the Truth in Lending Act, a “finance charge is the cost of consumer credit as a dollar amount. It includes any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of credit. It does not include any charge of a type payable in a comparable cash transaction.”
You’ll notice that the definition of a finance charge is pretty broad. That’s because there are many types of credit available — and each can come with different types of finance charges. For example, a credit card may have different finance charges than a mortgage.
- What makes a finance charge?
- Different types of finance charges
- Why understanding finance charges matters
While an official definition helps you understand what finance charges are, how do you figure out what is and isn’t a finance charge for the financing you’re considering? Here’s an easy way to determine whether something is a finance charge. Compare a transaction using credit to a transaction paid with cash. A finance charge is an expense you’d have to pay when using credit that you wouldn’t have to pay if you were using cash.
Borrowing money from credit card companies is very different from taking out a mortgage to purchase a home, so it makes sense that any finance charges for the two could be different.
When you’re applying for a credit card, the finance charges you may have to pay should be disclosed in a pricing and terms sheet. In particular, you should look for the following common credit card finance charges:
How is credit card interest calculated?
Many credit card issuers use your average daily balance to calculate your interest charges each billing cycle. If your card offers a grace period, you can avoid paying purchase interest as long as you pay off your balance on time and in full by the due date every month. Otherwise, the faster you pay off your balance, the less interest you’ll pay.
Figuring out the finance charges for a bigger transaction, like a mortgage, can be more complicated. There are more factors involved and the transaction is usually much larger. Here are some major mortgage charges to look out for.
- Interest paid
- Origination fees
- Discount points
- Mortgage insurance
- Other applicable lender charges: You should be able to find finance charges in the Loan Calculations section on Page 5 of your Closing Disclosure.
Being able to identify finance charges is a great skill to have. It allows you to compare finance charges between two similar debt options, so you can figure out which credit option is better for your situation based on the whole picture — not just the interest rate.
This knowledge can also help you determine if paying finance charges makes sense. If you’ll have to pay $50 in finance charges to pay off a $100 credit card purchase, you’re probably better off waiting — if at all possible — until you can afford to pay cash. But if you’d have to pay $1,000 in finance charges over the life of a three-year loan for a $10,000 vehicle that you need to commute to a higher-paying job, it could be well worth the cost.
In some cases, it may make sense to pick a loan with higher finance charges due to some other feature of the loan. For instance, you may have to pay more in finance charges for a loan with a longer repayment period, but it may come with a lower monthly payment that fits your budget better.
Once you understand what finance charges are, you can use that knowledge to choose the best borrowing options for you. Finance charges may not be limited to the interest you pay — look for other charges that you wouldn’t have to pay if you were making the same transaction in cash instead of with credit.
Finance charges are an additional expense for making a purchase. You’re paying for the ability to use someone else’s money. Sometimes this makes sense, but other times it may not be a financial decision that helps you in the long run. And remember: Though it’s not always possible, the surest way to avoid finance charges is to pay in cash.