Finance Charge

A finance charge is the dollar cost of consumer credit as defined by the Truth in Lending Act's implementing rule, Regulation Z. Under 12 CFR 1026.4(a) it "includes any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of credit," and "does not include any charge of a type payable in a comparable cash transaction." Interest is one piece of it. The finance charge also takes in points, loan and finder's fees, service and carrying charges, valuation and credit report fees outside real estate transactions, and premiums for insurance that protects the lender against your default.

The relationship to interest is worth stating plainly, because the two are often used as synonyms. Regulation Z never defines interest at all; section 1026.4(b)(1) simply lists it as one example of a finance charge. So every dollar of interest is part of the finance charge, but the finance charge can be larger than the interest by the amount of the fees the lender requires.

Charges imposed by someone else can still count. A fee charged by a third party is a finance charge if the creditor requires you to use a third party as a condition of the credit, even if you choose which one, or to the extent the creditor keeps part of the fee (1026.4(a)(1)). Fees charged by a closing agent, such as a settlement agent or title company, count only if the creditor requires the particular service, requires the charge, or keeps part of it (a)(2). Mortgage broker fees are finance charges even when the lender did not require a broker and keeps none of the fee (a)(3).

What is excluded. Section 1026.4(c) lists charges that are not finance charges: application fees "charged to all applicants for credit, whether or not credit is actually extended"; charges for actual unanticipated late payment, for exceeding a credit limit, or for delinquency or default; a bank's charge for paying items that overdraw an account, unless the payment and the charge were agreed in writing beforehand; fees for participating in a credit plan, such as a card's annual fee; seller's points; and, in a transaction secured by real property, bona fide and reasonable fees for title work, document preparation, notary and credit reports, appraisals and inspections done before closing, and escrow deposits for amounts that would not otherwise be finance charges. That last list is why the same appraisal fee is a finance charge on a car loan and not on a mortgage.

Insurance and debt cancellation are conditional. Premiums for credit life, accident, health or loss-of-income insurance, and fees for debt cancellation or debt suspension coverage, are finance charges unless the coverage is voluntary, that fact and the cost are disclosed in writing, and you sign or initial an affirmative request for it (1026.4(d)). Property insurance can be excluded if you may buy it from an insurer of your choice and that is disclosed, so a lender can require homeowners or collision coverage and still leave the premium out. If the lender requires credit insurance or debt cancellation coverage, its cost stays in the finance charge.

Two smaller rules. Taxes and fees paid to public officials to record or release a security interest can be left out if they are itemized and disclosed (1026.4(e)). And a lender may not shrink the finance charge by netting out interest or dividends you earn on a deposit or investment; the regulation calls that a prohibited offset (1026.4(f)).

Why the number matters. On a closed-end loan the lender must disclose the finance charge "using that term" with a description such as "the dollar amount the credit will cost you" (1026.18(d)), and the annual percentage rate is the finance charge expressed as a yearly rate on the amount financed. A fee taken out of the loan proceeds is a prepaid finance charge: it reduces the amount financed and raises the APR above the note rate. On a credit card the picture differs. The annual fee is excluded, and the periodic statement must group finance charges from periodic rates under the heading "Interest Charged" and other charges under "Fees" (1026.7(b)(6)), so a card statement rarely uses the words finance charge at all.

To find the finance charge on a loan, start with every charge connected to the credit, then ask of each one: would I pay this if I bought the same thing for cash, is it a late or default charge, or is it on the regulation's excluded list? What survives those questions, plus the interest, is the finance charge.

For example: Bettina borrows $10,000 for 36 months at 9% interest. The lender charges a $300 origination fee withheld from the loan proceeds, and a $25 application fee that it charges every applicant whether or not they are approved. Her payment is about $318 a month, so over 36 months she pays about $11,448, of which about $1,448 is interest.

• The $300 origination fee is a finance charge (a loan fee under 1026.4(b)(3)), and because it is withheld from the proceeds it is a prepaid finance charge.
• The $25 application fee is excluded, because it is charged to all applicants.
• Any late fee she pays later is excluded too.

Her finance charge is about $1,748 ($1,448 of interest plus the $300 fee). Her amount financed is $9,700, the $10,000 note minus the fee withheld. Measured against $9,700 rather than $10,000, the same $318 payments work out to an APR of about 11.1%, roughly two percentage points above the 9% note rate.

Pros

• Puts the required costs of borrowing into one disclosed dollar figure, so a loan with a low rate and heavy fees cannot hide them in the fine print.
• Feeds the annual percentage rate, which lets borrowers compare closed-end loans with different fee structures.
• Catches third-party charges the lender requires, so an outsourced fee still counts.

Cons

• It is narrower than the total cost of a loan. Late fees, application fees charged to everyone, and a card's annual fee are all outside it.
• On a mortgage, many closing costs are excluded if they are bona fide and reasonable, so the finance charge understates what closing costs.
• Voluntary credit insurance and debt cancellation coverage drop out once the written disclosure and signed request are in place, even if the borrower felt pressed to buy them.
• Card statements do not show a single finance charge, which makes comparing a card with an installment loan harder than it looks.