As a consumer these days it's easy to feel like you spend half your money on charges you don't see coming or, most of the time, even understand.
Order a $5 beer and the bill asks for $6.50 after taxes and tip.
Flying overseas? That discount ticket you got so excited over will cost an extra $200 in "departure charges."
Heaven help you if you've ordered concert tickets.
Added to this pile is the mysterious "finance charge," a line item that appears on many bills with typically little explanation. Most specifically, this is a common feature on credit card bills and other lending statements.
Here's what it means and what, exactly, you're paying for.
What Is a Finance Charge?
A finance charge is the amount of money charged by a lender in exchange for giving you credit. Put another way, it's the cost of borrowing money.
Finance charges can come in several forms, but the most common are:
• One-time fees charged when the loan is issued;
• Ongoing lump-sum fees paid each time a loan payment is made;
• Late fees if you fall behind on your payment;
• Any applicable service fees;
• Commitment fees for unused loans;
• Membership fees;
Of these, the most common finance charge is interest, as almost any professional loan will charge an interest rate.
It is important to understand that while most coverage of this topic discusses finance charges in the context of credit card debt, as will this piece for demonstrative purposes, they apply to all forms of lending. When you pay interest on your student loans or if you have an administrative fee as part of your mortgage, you are paying finance charges.
When Is a Finance Charge Assessed?
There is no single method for assessing finance charges. Lenders can calculate them at any point based on the details of the loan.
However, when your lender assesses a finance charge is actually quite significant. Particularly for percent-based charges, it can make a big difference in how much you pay. As an example, here is how credit card interest is typically assessed:
Your credit card has what is called a "billing cycle." This is the period of time during which any charges you make show up on your next bill. A credit card billing cycle is one month, although formally the credit card company might list the billing cycle as anywhere from 24 to 33 days depending on how it lists weekends and holidays.
At the end of each billing cycle your credit card company sends you a bill for that month's spending. 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 based on whether or not the previous bill was paid in full. If you paid your entire balance on the last bill then it doesn't apply any interest to the new one. If you have an unpaid balance at the end of a billing cycle it applies interest typically to both the previous balance and the most recent purchases.
To demonstrate, let's walk through a credit card with a billing cycle that started on May 5 and ended on June 4.
• May 4: at 11:59 p.m. the previous billing cycle ends.
• May 5: at midnight the new billing cycle starts. All purchases that you make on the credit card will now go on the next month's bill.
• May 5: the credit card company calculates and sends out your bill for the previous billing cycle. Let's assume that it's $1,000.
• May 26: the $1,000 bill for the previous billing cycle is due, as 21 days is the minimum payment period by law. You pay $500 of it.
• June 4: at 11:59 p.m. this billing cycle ends. You have made $1,500 in additional purchases over the past month.
• June 5 at midnight the new billing cycle starts.
• June 5: the credit card company calculates your bill for the May - June billing cycle. You have an existing balance of $500. The credit card company adds that to your $1,500 in new spending, then applies interest to the entire balance. It sends out a final bill based on your interest rate which will be due June 26.
• In the alternative: You pay the entire bill on May 26. In this case, on June 5 the credit card company calculates your bill from the most recent billing cycle. You have an existing balance of $0. As a result it charges no interest and sends out a final bill just for your most recent spending of $1,500.
How Is a Finance Charge Calculated?
There is no set formula for how lenders can assess a finance charge. Finance charges can be lump sum or based on a percentage of the loan. They can be one-time (like an initiation fee) or ongoing (like interest or membership fees). They can be part of a monthly bill or assessed based on specific circumstances (such as late fees).
Understanding how finance charges are calculated is critical. To understand that, here is an overview of how a typical credit card company charges interest.
As discussed 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 making purchases with any standard credit card.
Some certain types of spending do not have this grace period. Most notably, if you take out a cash advance, your credit card will usually begin to charge interest right away.
If you pay less than the full amount due, 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 going forward until the entire bill is paid. This means that if you owe $500 at the beginning of the billing cycle and make $1,500 in new purchases, you will owe interest on the full $2,000 at the end of that billing cycle.
While credit card companies used to charge interest on a monthly, lump-sum basis, today most of them use what is called the Average Daily Basis method. This means that the company charges interest on a daily basis for each purchase made. To calculate this the company:
• First divides your interest rate (the APR) by 365 to determine your daily rate of interest. For example, if you have a 15% APR your daily rate of interest would be 15/365 = 0.041%. Then the company multiplies your daily rate of interest 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 your statement interest rate by the outstanding balance. For example, if you have a balance of $2,000 at the end of a billing cycle with a 1.23% statement interest rate, you would owe $24.60 in interest.
Some companies also use what is called the Daily Balance method. Under this approach, the company calculates your daily rate of interest and then applies it to each day's current balance as the month goes on. Then the company adds all of those daily interest calculations together to get your total finance charge for the month. (This may seem enormous, but remember that the daily rate of interest is quite small.)
This is a less common approach.
How to Avoid a Finance Charge
There are some finance charges you cannot avoid. Any built-in service fees, for example, are inevitable. Some, however, you can get around. The most common ways to avoid finance charges are:
• Late Fees - Making your minimum payments can avoid late fees, which add up quickly and can often come to far more than the minimum payments themselves.
• Interest Rates - Paying any loan off early will reduce the amount you pay in interest.
• Credit Card Interest - The only way to avoid credit card interest is by making your full payment when each bill is due. If you do this, you will not get any finance charges. Otherwise, you will carry a balance and the credit card will charge you for it.
Introducing TheStreet Courses: Financial titans Jim Cramer and Robert Powell are bringing their market savvy and investing strategies to you. Learn how to create tax-efficient income, avoid mistakes, reduce risk and more. With our courses, you will have the tools and knowledge needed to achieve your financial goals. Learn more about TheStreet Courses on investing and personal finance here.