Finance charges represent the cost of credit, or the cost of borrowing. It is interest accrued on, and fees charged for, some forms of credit. They include not only interest but other charges as well, such as financial transaction fees. Details regarding the federal definition of finance charge are found in the Truth-in-Lending Act and Regulation Z, promulgated by the Federal Reserve Board.
In personal finance, a finance charge may be considered simply the dollar amount paid to borrow money, while interest is a percentage amount paid such as annual percentage rate (APR). These definitions are narrower than the typical dictionary definitions or accounting definitions.
Creditors and lenders use different methods to calculate finance charges. The most common formula is based on the average daily balance, in which daily outstanding balances are added together and then divided by the number of days in the month.
In financial accounting, interest is defined as any charge or cost of borrowing money. Interest is a synonym for finance charge. In effect, the accountant looks at the entire cost of settlement on a Housing and Urban Development (HUD) form 1 (the HUD-1 Settlement Statement) document as interest unless that charge can be identified as an escrow amount or an amount that is charged to current expenses or expenditures other than interest, such as payment of current or prorated real estate taxes.
A finance charge is a fee charged for the use of credit or the extension of existing credit. It may be a flat fee or a percentage of borrowings, with percentage-based finance charges being the most common. A finance charge is often an aggregated cost, including the cost of carrying the debt itself along with any related transaction fees, account maintenance fees or late fees charged by the lender.
Finance charges allow lenders to make a profit on the use of their money. Finance charges for commoditized credit services such as car loans, mortgages and credit cards have known ranges and depend on the creditworthiness of the person looking to borrow. Regulations exist in many countries that limit the maximum finance charge assessed on a given type of credit, but many of the limits still allow for predatory lending practices, where finance charges can amount to 25% or more annually.
Finance charges are a form of compensation to the lender for providing the funds, or extending credit, to a borrower. These charges can include one-time fees, such as an origination fee on a loan, or interest payments, which can amortize on a monthly or daily basis. Finance charges can vary from product to product, or lender to lender.
There is no single formula for the determination of what interest rate to charge. A customer may qualify for two similar products from two different lenders that come with two different sets of finance charges.
Finance Charges and Interest Rates
One of the more common finance charges is the interest rate. This allows the lender to make a profit, expressed as a percentage, based on the current amount that has been provided to the borrower. Interest rates can vary depending on the type of financing acquired and the borrower’s creditworthiness. Secured financing, which is most often backed by an asset such as a home or vehicle, often carries lower interest rates than unsecured financing, such as a credit card. This is most often due to the lower risk associated with a loan back by an asset.
For credit cards, all finance charges are expressed in the currency from which the card is based, including those that can be used internationally, allowing the borrower to complete a transaction in a foreign currency.
Finance Charges and Regulation
Finance charges are subject to government regulation. The federal Truth in Lending Act requires that all interest rates, standard fees and penalty fees must be clearly disclosed to the consumer. Additionally, the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 required a minimum 21-day grace period before interest charges can be assessed on new purchases.
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