As a consumer these days, it’s easy to feel like you’re spending half your money on charges that you don’t see coming or, most of the time, even understand.
Order a beer for $ 5 and the bill asks for $ 6.50 after taxes and tip.
Fly abroad? That discounted ticket that you were so excited about will cost an additional $ 200 in “tee-off fees.”
May heaven help you if you ordered concert tickets.
Added to that pile are the mysterious “finance charges,” a line item that appears on many invoices with usually little explanation. Specifically, this is a common feature on credit card bills and other loan statements.
Here’s what it means and exactly what you pay for.
What is a financial charge?
Finance charges are the amount of money charged by a lender in exchange for granting credit. In other words, it is the cost of borrowing money.
Finance charges can take many forms, but the most common are:
• One-off fees charged when the loan is issued;
• Ongoing flat-rate fees paid each time a loan repayment is made;
• Late fees in the event of late payment;
• All applicable service charges;
• Commitment fees for unused loans;
• Membership fees;
• Interest.
Among these, the most common finance charges are interest, as almost all business loans will charge an interest rate.
It is important to understand that while most of the articles on this topic deal with finance charges in the context of credit card debt, just like this article for demonstration purposes, they apply to all forms of lending. . When you pay interest on your student loans or have an administrative fee on your mortgage, you are paying a finance charge.
When is a financial burden assessed?
There is no single method for valuing financial charges. Lenders can calculate them at any time based on loan details.
However, when your lender considers the finance charges to be quite significant. Especially for percentage based fees, it can make a big difference in how much you pay. As an example, here’s how credit card interest is typically assessed:
Your credit card has what is called a “billing cycle”. This is the period during which any charges you make appear on your next bill. A credit card billing cycle lasts for one month, although formally the company that issued the credit card might say the billing cycle is 24-33 days depending on how it lists weekends and holidays. .
At the end of each billing cycle, your credit card company sends you an invoice for the month’s expenses. It then closes the billing cycle and begins a new one for the coming month.
A credit card company applies interest and finance charges at the end of each billing cycle depending on whether or not the previous bill was paid in full. If you paid your entire balance on the last bill, no interest is charged on the new one. If you have an outstanding balance at the end of a billing cycle, interest usually applies to both the previous balance and more recent purchases.
To demonstrate this, let’s take a look at a credit card with a billing cycle that started on May 5 and ended on June 4.
• May 4: At 11:59 pm, the previous billing cycle ends.
• May 5: at midnight the new billing cycle starts. Any purchases you make with the credit card will now be charged to the next month’s invoice.
• May 5: The credit card company calculates and sends your invoice for the previous billing cycle. Suppose it is $ 1,000.
• May 26: The $ 1,000 invoice for the previous billing cycle is due, as 21 days is the minimum statutory payment period. You pay $ 500.
• June 4: At 11:59 pm, this billing cycle ends. You made $ 1,500 in additional purchases in the past month.
• On June 5 at midnight the new billing cycle starts.
• June 5: The credit card company calculates your bill for the May to June bill cycle. You have an existing balance of $ 500. The credit card company adds this to your $ 1,500 in new spending, then charges interest on the entire balance. It sends a final invoice based on your interest rate which will be due on June 26.
• Alternatively: you pay the entire bill on May 26th. In this case, on June 5, the company that issued the credit card calculates your bill from the most recent bill cycle. You have an existing balance of $ 0. As a result, it charges no interest and sends a final invoice only for your most recent expenses of $ 1,500.
How are the finance charges calculated?
There is no set formula on how lenders can assess a financial burden. Finance fees can be flat or based on a percentage of the loan. They can be one-off (like an initiation fee) or ongoing (like interest or membership fees). They can be part of a monthly bill or they can be assessed based on specific circumstances (like late fees).
Understanding how finance charges are calculated is essential. To understand that, here’s a look at how a typical credit card company charges interest.
As noted above, credit cards only charge interest when you carry an existing balance from month to month. If you don’t have an existing balance, the credit card company won’t charge interest on your most recent purchases. This is called the “grace period,” and it applies to purchases with any standard credit card.
Certain types of expenses do not benefit from this grace period. Specifically, if you take out a cash advance, your credit card will usually start charging interest immediately.
If you pay less than the full amount owed, you lose the grace period. This means two things:
• First, you will be charged interest on the unpaid amount.
• Second, you will owe interest on all new purchases until the entire bill is paid. This means that if you owe $ 500 at the start of the billing cycle and make $ 1,500 in new purchases, you will owe interest on the entire $ 2,000 at the end of that bill cycle.
While credit card companies charged interest on a flat monthly basis, today most of them use what is called the Average daily basis method. This means that the company charges interest daily for every purchase made. To calculate it, the company:
• First divide your interest rate (the APR) by 365 to determine your daily interest rate. For example, if you have an APR of 15%, your daily interest rate would be 15/365 = 0.041%. Then the business multiplies your daily interest rate by the number of days in the billing cycle. For example, in a 30-day month at 15% APR, that month’s statement would have an interest rate of 1.23%.
• Finally, the company multiplies the interest rate on your statement by the outstanding balance. For example, if you have a balance of $ 2,000 at the end of a billing cycle with an interest rate on the statement of 1.23%, you will owe $ 24.60 in interest.
Some companies also use what is called the daily balance method. With this approach, the company calculates your daily interest rate and then applies it to each day’s current balance over the month. Then the company adds up all of these daily interest calculations to get your total finance charges for the month. (This might sound like a lot, but remember that the daily interest rate is quite low.)
It is a less common approach.
How to avoid financing fees
There are some finance charges that you can’t avoid. All built-in service charges, for example, are inevitable. Some, however, you can move. The most common ways to avoid finance charges are:
• Late fee – Making your minimum payments can avoid late fees, which add up quickly and can often exceed the minimum payments themselves.
• Interest rate – Prepayment of any loan will reduce the amount you pay in interest.
• Credit card interest – The only way to avoid credit card interest is to make your full payment when each invoice is due. If you do this, you will not have any financing costs. Otherwise, you will carry a balance and the credit card will charge you.
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