Understanding how to calculate finance charges is important, even when the lender or credit card provider does the task for you. By having an idea of the actual cost of credit or cost of borrowing that you are paying for those financial services, it is possible to know if what seems to be a good deal is really in your best interests. While factors other than the interest charges come into play, properly calculating those charges will be an important first step to evaluating any credit card or loan offers that come your way.
Before you can actually calculate finance charges, it is important to identify not only the amount of interest, but also how that interest is applied to the money you actually borrow, known as the principal. The interest rate is set forth very clearly in the terms and conditions related to the contract. Many people do not delve a little deeper and look at how that rate is applied to the outstanding balance. Some lenders will calculate interest based on a 360-day year while others will use a 365-day year. While this difference may seem small, it can make a significant difference in how much interest is paid over a long period of time on a large amount of principal.
Keep in mind as you calculate finance charges that those interest rates may be fixed or variable. Fixed means that the rate does not change over time, while variable means that the rates will shift in response to the average rates in the marketplace. It is still possible to accurately calculate finance charges in both scenarios, although you will need to always identify the current status of the rate before making the calculation.
Along with knowing the principal amount due on the loan and the rate of interest applied, it is also important to identify the duration of the loan period itself. With these three figures in hand, you can then calculate finance charges and determine if a particular loan or credit card deal is in your best interests.
For example, if a consumer wants to finance the purchase of a used car, the first step is to consider the rate of interest that the lender will apply to the amount that is borrowed to complete the car purchase. This in turn is influenced by how that interest rate is applied over the course of the year, either using the 360- or 365-day approach. From there, if the loan is structured for a series of 24 monthly installment payments, the consumer can use this data to determine how much will be paid in finance charges over the course of the loan.
One basic formula used to calculate finance charges would be to multiply the principal by the interest rate expressed as a percentage and then multiply that by the number of years involved in the loan term. This will provide the total amount of interest paid on the loan, assuming it is settled according to the loan terms. With this information in hand, the consumer can determine the principal and the total finance charges paid over the life of the loan, and add back in any other ancillary fees and charges included in the terms and conditions associated with the loan. Doing so makes it possible to determine the total amount, including the finance charges, that will be paid over time. Taking this approach with every loan offer will make it possible to look beyond just the interest rate and find the loan plan that is the most cost-effective over the long run.