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.

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Credit Cards Explained

Credit cards are a form of unsecured debt. A person qualifies for a credit card by filling out an application, listing his Social Security number, his income and employment,and other personal details. His credit limit (the amount of money he is allowed to borrow) and the interest rate (the amount he will be charged for borrowing the money) is based on his credit score and his income.

Definition of unsecured debt

Credit cards are considered unsecured debt because when you borrow the money, there is no collateral. When you buy a house or a car, for example, that is considered to be secured debt. If you do not make the payments the bank or the company that lent you the money can come and take your house or take your car. But you can use credit cards to buy whatever you want: groceries or toys or charge a plane ticket. If you do not pay your debt, the company can't come and take back a used plane ticket or groceries you have eaten. So the debt is not secured by anything. Unsecured debt, like credit card debt, usually has a higher interest rate.

What does interest rate mean?

The interest rate on your credit cards is the amount of money you are charged for using your credit. Most credit card interest rates are stated in terms of annual interest rate. So, for example, you could sign up for a credit card that has a 10 percent interest rate. That would mean that, over the course of the year, you pay 10 percent of the total amount of money you borrowed. Figuring out how much interest you actually pay can be somewhat tricky, though, because different credit card companies calculate interest differently. Some credit card companies calculate interest based on your average daily balance while others calculate interest based on monthly cycles or use a two-month cycle to calculate interest. If you have any questions regarding how your interest will be calculated, it is best to ask the creditor prior to filling out an application.

What does credit line mean?

The amount of money you have available to borrow is called your credit line. For example, if you have a $500 limit, that means you can borrow up to $500 at a time on that credit card. If you borrow the full $500 you are said to have "maxed out" your credit line or borrowed the maximum amount available. This behavior tends to lower your credit score. If you exceed your credit line or go "over the limit" you are usually charged a fee or a penalty.

What does minimum payment mean?

Your minimum payment is calculated based on the amount of money you owe. It is the minimum amount of money you have to pay on your credit card each month, in order to keep your credit card "current." If you fail to pay the minimum amount due by the due date, the credit card companies report that as a late payment on your credit report. You may also be charged a penalty, and the interest rate on your credit card might go up as a result of the late payment. The minimum payment is usually less than what you owe on your credit card, and in some cases does not even cover the monthly interest. If you pay only the minimums on your credit card, your debt can continue to grow larger despite the fact that you are making payments, and it may take you many years to pay off your credit balance in full.

What is my credit score?

Your credit score is determined by your use of credit cards (in part) and also determines your access to credit cards. Each time you borrow money the transaction and the resulting payments and interactions with the credit card company are reported to one (or more) credit bureaus. They keep a record of your credit history, and assign you a FICO score. 35 percent of your FICO score is based on your history of paying credit (including credit cards) responsibly and avoiding bankruptcy and judgments. 30 percent of your FICO score is based on how much you owe, and how close to your balance you are. 15 percent is based on the length of your credit history (longer is better). 10 percent is based on the amount of new credit you apply for (again, less is better). And 10% is based on the different types of credit you use (if you just have unsecured debt, your score will be lower than if you have a mix of secured and unsecured debt).

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How to Split Marital Debts

Nobody goes into a marriage expecting to get divorced. But the sad truth is that approximately 50 percent of all marriages will end in divorce. The painful process of divorce involves dividing what was once merged. Just as a couple's assets will be divided, so will their debts. Among the shared debts a couple will have to separate may include a mortgage, cars, personal loans, taxes and credit cards. Dividing the debts quickly may be particularly important if your spouse is spending money recklessly.

Instructions

1

Make a list of all of the debts that you jointly owe as a couple. Any debt that is in both of your names is included. However, individual debts are not included, unless your state laws vary. Debts that you incurred before the marriage also do not count.

2

Meet with a lawyer or count-appointed counselor. Getting professional help will help you learn about any applicable state laws. A lawyer or counselor can also act as a mediator, which may be necessary if your divorce is especially bitter. Divide your debts according to whom is most capable of paying for them, if you can agree upon this.

3

Borrow money to pay off your share of the marital debts, if possible. If you borrow money and do not owe on marital debts anymore, all the debts will be in your name alone. Consider negotiating with the creditors to try to lower your interest rate, so the debt can be paid off faster. This option is more likely to be available to you if you have good credit.

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Do You Have to Disclose a 10 Year Old Bankruptcy?

Bankruptcy is the worst possible credit event, with credit bureaus listing personal bankruptcies for a minimum of 10 years. Usually, it is not necessary to disclose a 10-year-old bankruptcy -- unless you are responding to a specific question on an official document, such as an application for credit or employment.

Considerations

Applications for employment or bankruptcy may ask if you have ever filed for bankruptcy. In that case, you should answer yes, even though a bankruptcy 10 years old may no longer appear on your credit report. Failing to disclose bankruptcy when asked about it is the same as lying on the application. An employer could dismiss a new hire for that reason, or a bank could cancel an automobile loan and repossess the vehicle.

Public Records

Bankruptcy information disappears eventually from credit reports, but remains available to the public from other sources. Bankrupcy is a legal action and records about a specific bankruptcy are also available though court databases. For example, an employer performing a credit and background check might not see the bankruptcy on credit reports if it is older than 10 years. However, a character check digging into court records could reveal the bankruptcy.

Decisions

People with 10-year-old bankruptcies should check their credit reports to determine if credit bureaus are still reporting the information. Even if the information no longer appears, people completing official documents should respond truthfully if asked about bankruptcy. Also, as part of a background check, a potential employer may ask for permission to check the applicant's credit -- without asking specifically about bankruptcy. In a case like that the applicant may choose to disclose a 10-year-old bankruptcy voluntarily, if the applicant knows that the information, for whatever reason, still appears on credit reports. The applicant may choose to include a letter explaining the 10-year-old bankruptcy and why it is no longer relevant, instead of allowing the employer to discover the bankruptcy through a credit check and arriving at a wrong conclusion.

Free Reports

AnnualCreditReport.com offers free credit reports from major credit bureaus TransUnion, Equifax and Experian. It is the only website specifically authorized by the Federal Trade Commission to distribute free credit reports under the terms of the Fair Credit Reporting Act. The federal law entitles people to three free credit reports during a 12-month period, including one from each of the major credit bureaus. Reports are available immediately to view or print through the website.

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How Much Does Filing Chapter 7 Cost?

Chapter 7 liquidation is a form of bankruptcy available to individuals and business entities. This procedure erases most of an individual's or business' debts and sells personal or business property to compensate creditors. Those who file for Chapter 7 bankruptcy are required to pay credit counseling fees in addition to court costs and optional lawyers' fees.

Credit Counseling Costs

Although business entities are exempt from this rule, individuals must receive credit counseling from a nonprofit agency no more than 180 days before filing for Chapter 7 bankruptcy protection, say the United States Courts. Even though authorized credit counselors are "nonprofit," they still must charge for their services. As of December 2010, these fees vary widely.

Administrative and Filing Fees

The United States Bankruptcy Court also assesses several nonrefundable fees and surcharges to individuals and business entities seeking to file for Chapter 7 bankruptcy. As of December 2010, this includes a $245 case filing fee, a $39 administrative surcharge and a $15 bankruptcy trustee surcharge. Filers must pay these fees when they file their bankruptcy petitions.

Lawyer Fees

Although the United States Courts do not specifically require individuals or businesses to hire lawyers to handle bankruptcy cases, many filers choose to get professional legal help. As of December 2010, the average cost of a bankruptcy attorney is $1,000 to $2,000, according to Bankruptcy Action, a consumer debt information service. Typically, individuals and businesses pay these attorney fees after their bankruptcy cases conclude.

Total Cost

According to Bankruptcy Action, as of December 2010 the approximate total cost of a Chapter 7 filing is between $1,300 and $2,300, including court fees and attorney costs. This does not include the credit counseling fees described in Section 1, which vary greatly. Additionally, the courts may require businesses filing for Chapter 7 protection to convert to Chapter 11 reorganization bankruptcy in certain cases. The cost for such conversion is $755 as of December 2010.

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Will My Credit Score Get Worse Once I Start Paying Charge-Offs?

An account charge-off, in which a bank essentially writes off your ability to pay your credit card debt, has a devastating effect on a consumer's credit score and is viewed negatively by creditors. Understanding your consumer rights and when to pay a charge-off will assist you in mitigating its overall effect on your credit score and may help lead to a quicker credit score recovery.

Credit Reporting Guidelines for a Charge-Off

According to the Fair Credit Reporting Act (FCRA), a charge-off can legally stay on a credit report for seven years from the date of the last serious delinquency and have a serious effect on your credit score. If a creditor assigns a charged-off debt to a collection agency, the falls off a credit report on the original date of the last serious delinquency or the date of the charge-off, whichever is later.

Managing a Charge-Off

The charge-off is among the most devastating of blemishes to occur on a credit report. If it is not managed correctly, the resulting blemish can affect your credit score for years to come and drain your wallet needlessly. Knowing when to pay and when not to pay can impact your credit score dramatically.

Considerations About Paying a Charge-Off

Whether you should opt to pay a charge-off is dependent on each individual situation. If you are applying for a loan or mortgage, the lender may require that the charge-off is paid in full before closing the loan. This is often done to allow a rapid refiguring of your credit score so that you qualify for the loan. Another instance in which paying a charge-off makes sense is when your credit report is in good overall standing and it's the only blemish on it. Often paying on a recently charged-off debt will allow your credit score to recover faster.

When To Seek Legal Advice

There are occasions when paying a charge-off makes no difference to your credit score. If you are considering filing bankruptcy, it is important to discuss with a legal adviser the implications of paying on a charged-off account. Often during a bankruptcy the charged-off account is overlooked. At times, filing bankruptcy can result in a faster credit score recovery than satisfying a charged-off debt because of the weight the existing scoring system places on a bankruptcy filing. Additionally, if the charge-off is close to meeting the FCRA reporting guidelines, the effect of paying on a charge-off may have little to no impact on the overall credit score.

Consumer Right to Dispute

It is important to review your credit reports regularly. The FCRA provides every consumer the right to dispute information contained in them, so if you suspect that there is inaccurate information in your credit file, promptly request that the credit bureaus investigate it. Removing expired information and being diligent about correcting errors will result in better credit management, leading to a faster credit score recovery.

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Unsecured Loans Laws

Unsecured loans are not tied to any property or asset. Instead, lenders decide whether to offer an unsecured loan based on the applicant's creditworthiness. This means that if you default on the loan the creditor cannot repossess any of your belongings. Such loans are covered by a few different federal and state laws.

Debt Collection

Should you default on your unsecured personal loan, your lender is within his rights to pursue repayment and even to sue you for the amount due. Additionally, your lender can send your unsecured debt to a debt collection agency. However, at that point the collection practices are limited by the Fair Debt Collection Practices Act. The debt collector is not allowed to discuss your debt with anyone but you and can call you only during reasonable hours. They may also not threaten you or pretend to be someone they are not. Violation of the FDCPA should be reported to the Federal Trade Commission.

Usury

Usury, also called predatory lending or loan sharking, is when an unreasonable interest rate is charged on a loan. Many states have laws limiting the interest that may be charged on loans. However, national banks are covered by federal rather than state laws. These banks can charge no more than twice the interest rate defined as usury in your state and may be further limited to rates no more than a few points above the Federal Reserve Discount Rate.

Truth in Lending Act

The Truth in Lending Act, passed in 1968, requires lenders to make important terms and costs associated with any loan clear to the borrower. This act does not limit the charges and fees that may be associated with a loan; it merely requires that they be clearly explained and presented in writing. Things that must be disclosed include the identity of the creditor, amount of the loan, annual percentage interest rate, finance charges, total payments that will be due, when payments will be due and any penalties for late payments, according to the FDIC.

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