How Are Finance Charges Calculated?

Overview of Finance Charges

Finance charges are one of the ways banks and other financial institutions earn money for the services they provide to customers, which include loans. Finance charges are calculated on the principal balance of the loan based on a stated interest rate. The financial institution or lender multiplies the current principal balance by the interest rate and compounds the interest daily or monthly. Most credit card lenders do not begin compounding interest on credit card balances unless the initial balance is not paid in full by the statement due date. Interest rates may be fixed or variable. Credit cards and equity lines typically have a variable rate, which means that the finance charges may be calculated by a different rate from one month to another. Mortgages and auto and personal loans usually allow the consumer to choose between higher fixed finance charges or variable interest rates that are initially lower than the fixed rates offered.

Simple or Compounded Daily Interest

Few business lenders still calculate simple interest to charge finance charges to a customer. However, it is common for private lenders and those holding land contracts to charge simple interest because it is easier to calculate and to track. To calculate simple interest, you multiply the principal balance owed by the stated interest rate and divide by 12 months to arrive at the finance charges for 1 month. For example, if you owe $1,000 and your interest rate is 5 percent, then your finance charges for the month are $4.17 ($1,000 x 0.05 = $4.17). When finance charges are compounded daily, you divide by 365 instead of 12, add the finance charge to the principal balance and repeat the step for each consecutive day. Each month requires approximately 30 calculations.

Fixed or Variable Interest

Finance charges are calculated using either fixed or variable interest rates. When the customer chooses a fixed interest rate for a loan, the financial institution will calculate the finance charges every month based on that interest rate. Financial institutions typically notify customers when a rate change is about to take place on a loan with a variable interest rate. If interest rates change in the middle of the month, finance charges will be calculated for that month using two different interest rates. In that case, the principal balance will be multiplied times the first interest rate divided by 365 and multiplied by the number of days that rate was in effect for the month that the rate changed. This step would be repeated using the second interest rate and the two totals added together to arrive at the monthly finance charges.