Finance Charge Definition Example How To Calculate

Finance Charge Definition

Explanation

This charge is a way for the lenders to earn some gains using the money they have to lend. However, there are risks attached with such a kind of income. It differs from transaction to transaction and is different for different borrowings like commercial borrowings like a car loan, house loan, personal loan. The rate and term are fixed depending on the borrower’s income level. There are set rates and brackets definedA lot of the lending depends on the borrower’sCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more which can easily be accounted for using the credit score. This number tells us about the credibility and financial reliability of the borrower.There is certain regulation to be followed when levyingLevyingA levy is a lawful process where the debtor’s property is seized when the debtor cannot pay the outstanding debts. It is different from liens, as a lien is only a claim against a property, whereas a levy is an actual property takeover to fulfill the obligation.read more finance charges, most of the nations have laws that limit this charge, having said that there are also countries that do not charge interest at all, like Islamic Banking doesn’t have a provision for charging interest on any of the money being lent out.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.

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Types

In a broader sense, there are two types of finance charges: the percentage of the amount borrowed, i.e., the interest, and 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 calculate the finance charge. Since most of the transactions differ, the charge is calculated accordingly.

Let us look at one simple and widely used formula, 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 December 2019, and the last payable date for the same is 6th January 2020. So, the charge is levied after 6th January 2020 daily until one does not clear the dues.

Let us assume that we do not pay this bill till 6th January and instead we pay it on 16 January 2020, so here the charges for ten days will be applied to us at a 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 mortgageMortgageA mortgage loan is an agreement that gives the lender the right to forfeit the mortgaged property or assets in case of failure to repay the borrowed sum and interest.read more of $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 the 30th of that month, which means he was 30 days late.

Mr. Smith will have to pay $24.66 interest on the missed EMI deadline and have to bear other financial charges of $20 for the late payment. Furthermore, it will also dent his credibility image as a borrower who will be accounted for in his credit score. So, the finance charges will be applied for 30 days (20000.1530)/365 = $24.66.

Purpose

The basic motive of the finance charge is forcing the borrower to repay the debt in the stipulated period or else resulting in the repayment of a higher amount. The cost is added to the transaction if the borrower fails to repay within the allowed 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 require it.It is a way for the lender to secure the amount and earn more money from surplus money by lending liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more.Since the charges are mostly regulated, and the government mostly designs the structures, it requires all the charges levied upon 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 it since the borrower will have liquidity at his disposal just by paying a certain amount. Though there are mostly limited charges to be imposed, there is always an upper limit on the interest rate set by the regulators, which will avoid market exploitation.