Finance Charge: Definition, Types And How To Avoid It

Financial transactions cost both you and the lender money to complete. That’s why finance charges are present on many different types of loans. We’ll explore what a finance charge is at its heart, some common charges you may encounter and how you may be able to minimize finance charges on your loans.

What Is A Finance Charge And Why Does It Matter?

A finance charge is a fee incurred for borrowing money from a lender or creditor. This is how lenders make a profit and lessen the risk of lending. 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

As a borrower, here are the most common finance charges you will likely come across:

• The interest rate is a percentage of the principal loan balance that the lender charges borrowers for loaning them money. You'll find this on a personal loan, auto loan, or mortgage This finance charge is tacked on to your monthly payment.
  
  Interest rates fall under two main camps: fixed, which means they stay the same for the life of the loan; or adjustable, in which they can fluctuate.
  
  So, how are interest rates on a loan or line of credit determined? A handful of factors come into play. For instance, economic conditions, such as the base rate, or index can impact the interest rate. The base rate is determined by the U.S. prime rate.
  
  Your credit score, credit history and payment history also play a role. It works like this: the stronger your credit score, the lower your interest rates.
  
  So why should you care about interest rates? The higher the interest rate on a loan, the more you'll pay in interest, and the more that loan will cost you.
• Annual percentage rate (APR) is the yearly cost of borrowing money from a lending institution. One way to think of an APR is that it includes interest plus any margin the lender charges.
  
  The mortgage APR folds in not only the interest rate, but also mortgage broker fees, points, and other fees on the loan. It's a more complete picture of the total costs of the mortgage.
  • Purchase APR. This is the APR applied to purchases you make on a credit card.
    You won't be charged interest fees if you pay your balance in full each month.
  • Cash advance APR. You'll be charged the cash advance APR when you take out cash against your line of credit. Cash advance APRs are known to be the highest types of APRs.
  • Penalty APR. Let's say you break one of the terms of your loan — for instance, you fall behind on your penalties — you'll be charged at a higher APR. The penalty APR may stay in effect and you pay that rate until you improve your track record and start making consecutive, on-time payments for a set period of time.
  • Introductory APR. This is a promotional APR that's intended to entice you to take out a loan or credit card. It's usually quite low — in some cases 0%. Introductory APRs only go into effect for a set amount of time, usually between 12 and 21 months. Once the period ends, your purchase APR kicks in.
  • Balance transfer APR. This is the interest rate you'll be paying if you opt for a balance transfer between two credit cards.
    
• An origination fee is charged upfront by your lender to process your loan. It's usually between 0.5% to 1% of your loan amount depending on loan type, and is often common with mortgages, personal loans, auto loans and student loans. While origination fees aren't usually applied to credit cards, you might find an origination fee to a home equity line of credit (HELOC).
• Late fees are what you’ll pay if you fall behind on your payments. These are found with most loans and lines of credit. You can only be charged one late fee per billing cycle, and the amount is capped.
• Closing costs are specifically found with mortgages. They're part of the home buying process and are needed to close on the home. Closing costs usually are anywhere between 3% and 6% of the loan amount. They usually include your down payment, title search underwriting fees, appraisal fees and mortgage discount points.
• Prepayment penalties are what you might be charged if you end up paying off your loan early. This helps the lender offset any losses in interest they would've earned. Many lenders don't have prepayment penalties, but you'll want to comb carefully over your loan terms to make sure.

Common Examples Of Finance Charges

Let's take a look at some scenarios where you'll most likely encounter a finance charge:

• Getting a cash advance. Cash advances are a type of finance charge on a credit card. Let's say you're financially squeezed and need cash quickly. You decide to take out a cash advance. If so, you'll be charged the cash advance APR – this is the cost of borrowing cash from your credit line.
• Paying off your loan early. If you take out a personal loan to, say, cover an emergency expense, and pay it off early, you might get hit with this finance fee. As mentioned, not all loans come with prepayment penalties so be sure to check with your lender before paying off a loan early.
• Falling behind on your car payments. If you end up being late on an auto loan payment, expect to get penalized with a late fee. There's usually a 15 – 30-day grace period. Once the period ends, you're looking at anywhere from $25 to $50.
• Closing on a home. When you close in on a home you'll need to pay origination fees. This is a one-time, upfront fee, usually anywhere from 3% to 6% of the loan amount.

Tips To Lower Finance Charges

The Bottom Line

While lenders and creditors are happy to extend qualified borrowers financing, they won't do it for free. As we talked about, finance charges are the costs that come with borrowing money. To stay on top of any finance charges on your loans, shop around, read the fine print and be a responsible borrower.