A finance charge is any extra money or fees over the principal that the borrower has to pay to the lender.
Types of financial charges along with examples:
This can be in the form of interest, transaction fee, origination fee, maintenance fee, or a late fee.
Any fees incurred during a money lending activity are termed as finance charges.
The most popular financial charge is an interest charge for a loan amount. The borrower is required to return the principal along with the interest charged, to the lender. This interest is calculated based on the percentage as decided by the regulators. The regulators can be financial institutions like banks, insurance companies, or the borrower himself.
Now, let’s say the lending requires an affidavit from the judicial court as proof of contract. Then, the legal expense will be termed as the origination fee and is paid by the borrower.
This case is not about loans but the banks charge a maintenance fee even for the savings account. You must have seen a nominal charge of Rs.15 or Rs.20 debited from your account. This is simply because banks maintain our accounts, make transactions on our orders, and keeps the account up to date at any point in time.
Coming back to borrowing and lending. In case the borrower defaults, he has to pay a late penalty as set in the contract between the borrower and lender. A certain percentage can be calculated for the number of days the borrower has defaulted.
Let’s suppose, Mr. Karthik had to pay back Rs. 16000 to Mr. Ravi, his lender, on the 30th of June. Mr. Karthik paid on the 10th of July. He defaulted for 10 days. As per the contract, the late fee percentage is 10%. Then, the late fee that Mr. Karthik needs to pay is Rs. 43.83, calculated as follows – (16000*0.1*10)/ 365.
Credit card facilities involve a financial charge too. A credit card allows the user to transact an amount more than his bank balance. Thus, it is like a loan that the bank extends. Credit card users are supposed to pay back the extended credit on a stipulated date. If the credit card user is unable to perform his obligation, he will have to pay interest (a certain percentage on the loan amount considering the days he has defaulted for). The interest which is a form of penalty is calculated similarly as done in the previous case.
Why do we have finance charges?
A finance charge exists so that the lenders can earn some profit when they extend credit. This acts as their motivator to allow others to use their money.
The level of interest on loans differs from borrower to borrower. If a borrower’s credit score is high, he will be asked to pay a lower interest. Whereas if someone’s credit score is on the lower side, generally, a higher interest has to be paid. This is because there is a higher chance of default from a low credit scorer.