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.
Basics of Finance Charges
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
You will almost always need to pay interest on a loan, unless you are lucky enough to score zero percent interest. Although interest may be unavoidable, you can try to avoid some of the other fees that might be included in your finance charge. 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.
Limits on Credit Card Fees
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 Consumer Financial Protection Bureau, a credit card company can't charge you more than a $27 late fee the first time you are late with a payment. In addition, a late fee cannot exceed the amount of your minimum required payment.