Any time you take out a loan or use a credit card, a lender takes on risk. Imagine lending money to a friend who often forgets to pays back his debts. You'd probably want some extra compensation to justify the risk of lending to such a friend. It is the same with banks and other lenders: there is chance that borrowers will fail to make payments, so they charge fees to make up for the risk. Finance charges and interest rates are closely related terms that describe costs lenders impose on borrowers.
Finance Charge Basics
A finance charge represents the total amount you pay to a lender for borrowing money. According to the Truth in Lending Act, a section of the U.S. Code established to protect consumers against predatory lending practices, a finance charge is the total of all charges paid by the borrower and imposed by the creditor as a condition of extending credit. The finance charge includes interest as well as any other fees paid to the lender. Sometimes people refer to finance charges as fees that are separate from the interest rate, but technically, interest is a part of the total finance charge.
Types of Charges
Lenders can impose all sorts of charges that contribute to the finance charge. The interest charge forms the largest portion of the total finance charge for most debts. The interest charge is based on a percentage of the total amount borrowed. Other common fees that contribute to the finance charge include annual account fees, late fees, over-the-limit fees, cash advance fees and application fees.
Interest vs. Other Finance Charges
The interest charged on a debt and other charges that make up the finance charge often differ in that interest is unavoidable. When you borrow money, you always owe interest unless you pay the lender back immediately or during a promotional period of zero percent interest. Many common charges -- like late fees, over-the-limit fees and cash advance fees -- are only incurred if you fail to use your account responsibly. For some borrowers, the interest rate makes up the entirety of the finance charge, because they manage to avoid other fees and costs.
Uncle Sam might not seem like a friend when it comes to taxes, but the federal government has laws in place that limit fees credit card companies can add to your finance charge. According to the Federal Reserve Board, a credit card company can't charge you more than $25 as a fee for a late payment unless one of your last six payments was also late. In addition, late fees cannot exceed the amount of your minimum required payments.
- U.S. Code: 15 USC § 1605 - Determination of Finance Charge
- U.S. Federal Reserve: Finance Charges for Consumer Credit under the Truth in Lending Act
- U.S. Federal Reserve: New Credit Card Rules Effective Feb. 22
- U.S Federal Reserve: Credit Card Fees
- U.S. Federal Reserve: New Credit Card Rules Effective Aug. 22