Finance Charge (Definition, Example)| How to Calculate?

Finance Charge Definition

Finance Charge can be termed as a cost of borrowing or cost of credit and is the accrued interest or the fees which have been charged on the approved credit facility; at times there is a flat fee for the charge, however, most of the time it is percentage of the borrowing of extended line of credit.

Explanation

This charge is a way for the lenders to earn some gains using the money they have to lend, however, there are risks too attached with such kind of income.
It differs from transaction to transaction and is different for different types of borrowings like for commercial borrowings like cars loan, house loan, personal loan there are set rates and brackets defined, depending on the income level of the borrower the rate and term are fixed.
A lot of the lending also depends upon the creditworthiness of the borrower, which can easily be accounted for using the credit score, a number which tells us about the credibility and financial reliability of the borrower.
There is certain regulation to be followed when levying finance charge, most of the nation have laws which limit this charge, having said that there are also countries which do not charge interest at all like Islamic Banking doesn’t have a provision to charge interest on any of the money being lent out.
At times there is also a one-time fee attached to this charge like fixed fees or a transaction cost, this cost adds up to the overall charges.

Types

In a broader sense, there are really two types of Finance charges, one is the percentage of the amount borrowed i.e. the interest and the other one is the fixed fees being paid during or before the transaction i.e. The fees.
Most of the charges fall under this category and these charges have to be borne by the end consumer or borrower as per the set guidelines by the regulatory authorities.

Finance Charge Formula

There is no one rule to follow when we do the calculation of the finance charge since most of the transaction differs from one another the charge is calculated accordingly.

Let us look at one the simple and widely used formula which is a percentage of the amount borrowed.

Finance Charge Formula = (outstanding amount * interest rate * no of days) / 365

How to Calculate Finance Charge?

Suppose we have a bill of $350 for the month of December 2019 and the last payable date for the same is 6^th January 2020. So, the charge is levied upon after 6^th January 2020 on a daily basis till the time one does not clear the dues.

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Let us assume that we do not pay this bill till 6^th January and instead we pay it on 16 January 2020, so here the charges for 10 days will be applied to us at 20% interest rate.

Calculation of the finance charges for 10 days will be, (350 * 0.20 * 10) / 365 = $ 1.92, so the borrower will have to pay the final amount of $350 + $1.92 = $351.92.

Example of a Finance Charge

Let us take an example of Mr Smith who has a mortgage loan $2000 and his monthly EMI is $100 for 20 months which includes 15% interest per annum.

Smith is very regular in his payments every month except for one month where he miscalculated and couldn’t pay his EMI on time. He paid the EMI on 30^th of that month which means that he was late by 30 days.

So, here the finance charges will be applied for 30 days, (2000*0.15*30)/365 = $24.66, Mr Smith will not only have to pay $24.66 interest on the missed EMI deadline but will also have to bear other financial charges of $20 for the late payment. Furthermore, it will also dent his credibility image as a borrower which will be accounted for in his credit score.

Purpose

The basic motive of finance charge is forcing the borrower to repay the debt in the stipulated period of time or else resulting in the repayment of a higher amount. The cost is added in the transaction if the borrower fails to repay within the allowed time period.
For instance, in credit card cash you still might have to pay the charge even if you pay your dues within the time-frame, the charge is for lending you the liquidity when you required it.
It is kind of a way for the lender to secure the amount and to earn more money from surplus money by lending the liquidity.
Since the charges are mostly regulated and the structures are mostly designed by the government it requires to disclose all the charges to levied upon on the borrower to be disclosed initially to the borrower, so there is minimal risk of any further hidden costs.

Conclusion

The finance charge is a kind of gain for the lender and an expense for the borrower, but the cost is worth since the borrower will have liquidity at his disposal just by paying a certain amount. Though there are mostly limited charges to be imposed, however, there is always an upper limit on the interest rate set by the regulators which will avoid market exploitation.