Banks, as we all know, make a profit by moving money from one place to another. They charge various fees for this service; in the case of loans, these can be called finance charges. Simply put, a finance charge is what borrowing money costs you.
In other words, finance charges include any money you pay over and above what the cost would be if you dealt in cash. Interest is the most obvious example, but unlike interest rates, finance charges are expressed as a dollar amount and not a percentage.
Aside from making money – banking is a business. After all – the role of financing charges is to cover administrative costs. These vary depending on what kind of loans we’re discussing. A small personal loan may be quick to issue, while any bank will do a reasonably intensive background check before signing a mortgage. The finance charge on buying a house is, therefore, higher than that on a routine transaction.
Example: Car Loan Finance Charges
When you purchase a car with cash, or more likely a cash-like instrument like a check, things are pretty simple: you hand over an envelope and receive your keys and registration. With a car loan, finance charges get added to what you’ll end up paying.
If the dealership fills out the auto loan form for you, they will probably tack on an origination fee of between one and two percent. This fee is essentially the commission they earn for referring you to a lender, but it comes out of your pocket. The lender, for its part, charges you interest for the privilege of using their money and the risk they take by lending it to you.
Example: Credit Card Finance Charges
The first finance charge associated with credit cards is the merchant fee. Companies roll this charge into the sticker price, so you’ll probably not even be aware of it. On the other hand, this is why some retailers offer a small discount when paying with cash.
The finance charges you should begin to concern yourself with are with a balance transfer fee. When you switch credit cards, you typically move your outstanding amount from one company to another. You will probably pay a small percentage of the total to do this, but get a lower interest rate for the first couple of months you use the new card – sometimes, this interest rate is zero.
Once the introductory period expires, you’ll be subject to the typical APR or Annual Percentage Rate. This charge comes from a percentage that’s tacked on to your balance at the end of each month. In principle, it includes all routine fees. Credit card interest rates are typically very high compared to other types of loans, which is why it’s so important to pay them off quickly. If you owe $1,000 at the start of January, for instance, you may have to repay $1,017 in February. If you make no payments at all, that will have grown to $1,219 by the end of the year.
Another thing to be aware of is that cash advances on your credit card are treated differently from standard purchases. You’ll typically pay a higher APR on these as well as other charges.
Calculating (and Minimizing) Finance Charges
Working out how much you’re paying over the basic price when buying on credit can be a real eye-opener. Buying a car for $20,000 may look like a great deal, but paying it off over five years at 5% APR means it costs you $22,645, even without any other finance charges.
Your loan or credit card agreement should contain a section that spells out all of the loan costs. To calculate the finance charge, simply subtract the base price from the total you’ll have to pay. Online calculators can also come in handy for a finance charge calculation, especially for compound interest. Remember, though, that this assumes that you don’t make any late payments.
If this number seems too high, you can always try to negotiate with the lender – more often than not, they do have some room to maneuver on terms like the APR. If you still think you’ll be paying too much, you should look at other options, including waiting a while until your credit score has improved.
At the end of the day, however, borrowing money always costs money. The best way to reduce finance charges is really to borrow the smallest amount that will allow you to achieve your goals, for instance, by making a larger down payment on significant purchases.
The Devil in the Details and the Fiend in the Fine Print: Finding Finance Charges
Whenever you’re deciding on a lender, the first thing to do is make sure that you’re entirely clear about all the terms of your loan agreement. According to the Truth in Lending Act, each lender has to provide you with all relevant information in a clear and accessible form. They are still, however, more interested in your signature than your understanding, so spend as much time as you need to reviewing the contract, reading through their website, and asking questions.
Some of the terms can become a little confusing. Your credit card, for instance, probably has a grace period, meaning a number of days in the billing cycle you can go without paying for a new purchase before the interest clock starts ticking. This is why you need to persevere: unless you understand what you’re getting into, it’s probably a bad deal.