By Megan Doyle | American Express Credit Intel Freelance Contributor
3 Min Read | January 17, 2020 in Cards
Imagine lending a significant amount of money to a stranger. You’d probably want some kind of extra compensation or collateral to justify the risk, right? Now, imagine you’re a credit card company extending credit to millions and millions of people, despite the chance that some card members will fail to make their payments.
Enter the “finance charge.”
Most credit cards come with finance charges, largely to compensate the lender for the risk of non-payment. But what exactly do finance charges include, how are they calculated, and can they be avoided?
Put simply, a finance charge is any charge associated with using credit. In the language of the law—more specifically, the Truth in Lending Act—a finance charge is “the sum of all charges, payable directly or indirectly by the person to whom the credit is extended, and imposed directly or indirectly by the creditor as an incident to the extension of credit.”1
When your card issuer sends you your monthly statement, it lists any finance charges along with your purchases and payments. How your finance charge shows up on your statement will depend on your card issuer. For example, it might be listed in a separate finance charge category, or the statement might just list all the components that make up a finance charge (e.g., interest, foreign transaction fees, annual fees, cash advance fee, etc.) right in with your purchases and other activity.
Finance charges include any fees paid to the lender, such as:2
The most common type of finance charge is the interest that you’re charged if you don’t pay off your credit card balance in full every month. Most other fees are usually flat fees, such as annual fees or late fees. Some credit cards may charge flat fees for cash advances or balance transfers, too. Other finance charges, such as foreign transaction fees, are typically calculated as a percentage of the transaction value.
While the term “finance charge” is typically used in the context of credit cards, other forms of credit—personal and auto loans, or mortgages—may have finance charges, too. With any kind of credit, finance charges help lenders cover the nonpayment risk of extending credit and give them a way to make money by lending money.3
With loans and mortgages, finance charges can include a one-time loan origination fee as well as interest payments.
Since your finance charge depends on multiple factors, including the account balance and your card’s interest rate, it will typically vary from month to month. Each charge is calculated separately, based on the rules in your card member agreement. To understand how interest charges are calculated, see “How to Calculate Interest Rates.”
By way of example, say you didn’t pay off your credit card balance in full by the end of the grace period. You also withdrew a cash advance and made a few foreign purchases this month. Depending on your credit card’s terms, your finance charge might include:
Some card companies have a minimum finance charge (often $1); you’ll be charged a dollar even if your calculated finance charge is less than that.
It can be tough to avoid finance charges altogether, but there are ways to minimize them:4,5
Extending credit to millions of people is a risky business, so credit card and loan issuers use finance charges to generate revenue and make up for the risk of non-payment. Your credit card finance charge may vary each month, but usually includes a combination of percentage-based and flat-rate fees like interest, foreign transaction fees, and annual fees.
1 15 USC Chapter 41, Subchapter I: Consumer Credit Cost Disclosure, Office of the Law Revision Counsel, U.S. Code
2 “Interest Charge Vs. Finance Charge,” The Nest
3 “Finance Charge,” Investopedia
4 “Finance Charge Definition,” The Balance