The cost of borrowing money depends on several factors, including the interest rate, fees the borrower pays to open the loan or line of credit and ongoing fees the borrower pays for the privilege of using credit. The term "finance charge" refers to any fee charged to the borrower, including, but not limited to, interest charges.
Finance Charge Components
Monthly interest is just one of the components in the finance charge. The loan origination fee is a finance charge that the borrower has to pay up front. The annual fee is a recurring finance charge. People who make a late payment usually have to pay a late fee, which is another type of finance charge. Credit cards also usually bill finance charges for balance transfers or cash advances.
Calculating Interest Charge
In most cases, the lender calculates the interest charge by multiplying the balance owed by the periodic interest rate. For example, with a mortgage, divide the annual interest rate by 12 to find the monthly interest rate and multiply this by the balance at the beginning of the month to calculate the monthly interest. With a credit card, the balance for the purposes of interest is often the average daily balance, not the statement balance at the end of the month. Some loans, such as student loans, calculate interest for each day and multiply by the number of days since the last payment to get the interest charge.
Terminology
The term "finance charge" is sometimes used synonymously with "interest charge." This is especially true in situations where the interest charge is the only finance charge. Therefore, be careful that you include all other finance charges, not only the interest charge, when you determine the cost of borrowing.
Considerations
Use finance charges, rather than just interest charges, to compare the cost of borrowing from different sources. For example, if one credit card has a low interest rate, but charges an annual fee and an application fee, the total finance charge on that card could be more than the finance charge on a card that only charges interest each month.
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