Most of us with credit cards still remember what it felt like toget a credit card for the first time. While an exciting moment and a significant milestone, it can also be confusing and perhaps even a bit intimidating.
When trying to manage a credit card responsibly, you may have found yourself scratching your head over the term "finance charge" on your statement. Don't worry, though. It's just a fancy term for the cost of borrowing money.
When you swipe your card, you're basically renting money from the bank. That's what a finance charge is in a nutshell. Understanding this term in more depth will help you understand why credit card debt can be one of the most expensivetypes of debt — and how to feasibly manage it. You'll then be able to enjoy the perks of credit cards without too many fees!
So, whether you’ve just received your first credit card in the mail or just have some brushing up to do before talking finance with your kids, here’s everything you need to know about finance charges.
Parents, meet finance charges
The key to financial success? Well, there are actually a few, but one is knowing what’s in the terms and conditions of yourloans and credit cards. Most banks use fancy words that can be difficult to follow, but we’ll break down what a finance charge is so you can teach your kids and teens their ABCs of managing money.
What is a finance charge?
Finance charges are all fees associated with borrowing money. Simple as that!
With that said, finance charges come in different flavors. Most credit cards come with the following types of finance charges:
Annual fee: This is the fee you pay every year to be a cardholder. Think of it as a membership fee.
Monthly interest charge: This is what you pay for carrying a balance on your credit card. For example, let’s say your statement balance is $100 and your minimum payment is $20. If you only pay the minimum, the remaining $80 gets carried over into your next billing cycle. This amount will accrue interest according to your credit card’s annual percentage rate (APR), which will show up on your next statement as a finance charge.
Late fees: Some credit card companies will charge you a late fee for not making the minimum payment. As opposed to interest charges, these are generally flat fees — say $25 for each missed payment.
Cash advance fees: Some credit cards will allow you to withdraw cash from the ATM. However, unlike swiping your credit card to make a purchase, cash advances start accruing interest immediately. So, while you won’t pay interest on regular purchases as long as you pay your credit card in full each month, cash advances will start accruing finance fees the moment you withdraw the cash from the ATM.
Foreign transaction fees: Some credit cards will charge you a small fee for making transactions with foreign businesses. Not only does this mean that your trip to Mexico or Europe might be a bit more expensive, but it also means that you need to be careful when shopping online. You may get charged a foreign transaction fee if you purchase a videogame from a Japanese website or order a dress from a store in the UK.
These are just some of the most common types of finance charges out there, but remember that no two credit cards are the same. Your credit card might have more unique fees, so it’s always crucial to read your credit card agreement in full to understand what your finance charges are and how to avoid them.
Why do I get charged?
Banks and financial corporations charge fees as a way to generate revenue. For example, let’s consider the monthly interest charge on a credit card. If you carry a balance of $1,000, that means that you’ve borrowed $1,000 from your credit card company that it can no longer use elsewhere. The credit card company can't use that $1,000 to invest or lend to other customers. So, they want a little something in exchange for letting you have that money for longer.
How is a finance charge calculated?
Now that you’ve got a solid idea of what a finance charge is, let’s take a look behind the scenes to see how it’s calculated. Don’t worry, there won’t be any pop quizzes at the end!
The math behind finance charges
Most finance charges are really quite simple: They’re just flat fees. For example, your credit card may have an annual fee of $95 and charge you a $25 late fee for failing to make the minimum payment by the due date. Easy peasy.
However, interest charges are a bit harder to calculate. Most credit cards use the average daily balance method to calculate finance charges. The formula for calculating it is:
(average daily balance x APR x number of days in the billing cycle) / 365
The difficult part here is knowing your average daily balance if it’s not included in your statement. It doesn’t involve a lot of complex math, but you will have to add up the balance at the end of each day and divide it by the number of days in the billing cycle. Let’s take a look at the following daily balances:
Day 1: $1,500
Day 2: $1,600
Day 3: $1,725
Day 4: $2,000
Day 5: $2,300
For simplicity’s sake, let’s assume there are only five days in the billing cycle. In this case, you add up the balance of all five days and then divide it by 5. That gives us an average daily balance of $1,825.
Now, going back to our formula. Let’s say your credit card’s APR is 20%. Our total finance charge will be:
($1,825 x 0.20 x 5) / 365 = $5
So, you’d be paying just $5 in finance charges for carrying an average daily balance of $1,825 for five days. It might sound like a low price, but you’d end up paying $365 in finance charges to carry the same amount for a full year!
Tips to avoid or lower your finance charges
Nobody likes paying for credit card fees, right? Fortunately, savvy credit card users can avoid most finance charges completely — but only if they know how to use their credit cards wisely. Let us show you how.
Paying off your balance
If you want to avoid paying finance charges, then you must pay your credit card in full each month. That means paying off the statement balance — not the minimum payment due — completely by the statement due date.
Picture this: You go skiing with your family, and the shop attendant offers to let you borrow a pair of skis for free. However, there is one catch — you must return the skis by 5 PM, or else you’ll have to pay a fine of $1,000. So, what would you do? Return the skis by 5 PM, of course! It’s the same concept with your credit card statement. Pay the statement amount in full by the due date and avoid the finance charge!
Choosing the right credit card
Not all credit cards are created equal, and some come with lower fees than others. That’s why you should always consider thepros and cons of a credit card before signing up, as they all have different fees and perks.
In addition to avoiding credit cards with high APRs, you should also try to steer clear of credit cards with high:
Foreign transaction fees, if you travel often
Late payment fees
Returned payment fees
Cash advance fees
Card replacement fees
If you're curious about credit options that help you avoid the above, check out Greenlight's offerings. You won't have to worry about hidden fees, and you can earn up to 3%* cash back on purchases.
Wrapping up
Not so bad, was it? Finance charges can add up when you're not paying attention, but luckily, now you know exactly what they are and how to avoid them. If only everything in life were that easy!
Now that you know all about finance charges, why not loop your kids and teens in early and teach them about money before they have to deal with it all on their own? With Greenlight’s money app¹ and debit card, you can help your kid or teen learn about building credit. It comes with plenty of financial literacy resources, instant money transfers, and flexible parent controls. Sign up today — one month, our treat.
*Earn 3% when you spend at least $4,000 in a billing cycle, 2% when you spend at least $1,000 but less than $4,000 in a billing cycle, and 1% when you spend <$1,000 in a billing cycle. See the Credit Card Rewards Terms and Conditions for details, including earning, redemption, expiration or forfeiture.
¹Greenlight is a financial technology company, not a bank. The Greenlight app facilitates banking services through Community Federal Savings Bank (CFSB), Member FDIC.
