Finance charges are fees associated with the cost of making purchases on credit. You may have heard the term “finance charge” when discussing a loan or looking over a credit card agreement, but what exactly does it mean for your business?
In this post, we’ll discuss finance charges in general, explain what they mean for your bottom line, and provide examples, so you can decide whether to use them in your business. Continue reading for an in-depth look at finance charges, or use the links below to navigate to the section that best answers your question.
- What is a finance charge?
- How does a finance charge work?
- How to calculate finance charges
- Paying off a finance charge
- Finance charges and interest rates
- Finance charges and regulation
- Final notes: Using finance charges in your business
What is a finance charge?
In general, a finance charge is a broad term for the cost associated with borrowing money. For small business owners who offer credit to their customers, it can refer to a fee imposed on clients whose payments are overdue.
Recent research by QuickBooks shows that nearly 1 in 4 payments to small businesses are late. It costs time, resources, and money when customers don’t pay on time, and late payments can impact your cash flow. That said, there are numerous types of finance charges you could use to ensure you have enough funds to pay essential bills and your employees’ paychecks. If you choose to use finance charges, any fees must be disclosed per the federal Truth in Lending Act, or TILA, which we’ll explain later on.
Examples of a finance charge
Let’s say a client makes a purchase of $200 at your business, and you both agree on net 30 payment terms. However, they only manage to pay $33 by the payment due date, leaving them with an outstanding balance of $167. Because they didn’t pay the complete amount, this balance will remain unpaid, and you’ll now have to assess a late fee. This late fee is a kind of finance charge.
Finance charges vs. interest rates
While interest rates are a type of finance charge, the two are quite different and shouldn’t be used interchangeably. As mentioned, finance charges are extra payments you make beyond the original amount paid. Interest charges, on the other hand, are a certain percentage that are based on how much you spent, amount of funds being borrowed, or overall creditworthiness. It’s also one of the most common types of finance charges that users may experience.
How does a finance charge work?
A finance charge is a fee that is charged as interest accrued on your customer’s account with your business.
On your invoices, you’ll likely specify payment terms that outline a specified window to receive payment. Net 10, net 30, and net 60 are common payment terms, which mean your customer must pay in 10, 30, or 60 days.
Finance charges on invoices often enter the picture when this payment window has elapsed, sometimes following a grace period that may be 7, 10, or 14 days. After this grace period, you will want to start charging interest—enough to cover your credit card processing and other financial transaction fees that result from nonpayment on the invoice.
Placing charges on a bill
Finance charges are typically included within a customer’s invoice. The invoice should make it clear what the one-time or monthly payments are to avoid confusion. Make sure to have a discussion with your clients before putting a charge on their invoice.
In addition to discussing these fees with your customers at the beginning of a new engagement, you’ll want to send several notifications to help your customers avoid overpayment. Alert your customer a week before your payment is due and a day after the invoice due date has elapsed. At that point, you will want to send a finance charge letter as a heads-up that you’ll charge interest if the payment continues to be late.
How to calculate finance charges for your small business
Once you’ve determined your finance charges, you can begin to calculate them by doing some simple math. Let’s say you have a late fee of 5% for every month your customer doesn’t pay their bill. You would multiply 5% by the amount they owe. The same math applies if you’re charging a daily fee.
While the math may be simple, it can add up if you have multiple finance charges to calculate. You make this process much easier for you and your team by using accounting software. QuickBooks can help you identify clients with past due invoices, automate finance charge calculations, and send payment reminders.
Helping customers pay off a finance charge
Nobody likes to see their bills balloon into bigger bills. An understanding of real, material consequences of paying late will encourage your customers to take care of what they owe on time. However, if you’re going to have finance charges, you need to make it easy for customers to repay their debt. A payment processing system that’s too difficult for them to use can create an unnecessary barrier and prevent them from paying altogether. After all, you want to continue building long-lasting customer relationships.
Be firm with the payment terms and conditions you’ve established, but also remember to be understanding and polite. Being concise, clear, and consistent with your collection attempts can help you maintain a positive cash flow while minimizing costs.
Even if your business creates a standard policy for charging interest, each debt and customer needs evaluation and consideration. Factors like the length of the business relationship or payment history may influence your decision. Finance charges have numerous benefits for your business, but as you weigh your options, consider the implications they have for your customers as well.
Finance charges and regulations
It’s important to keep tabs on rules and regulations regarding the use of finance charges in your small business. Finance charges are regulated by the government per TILA, which requires lenders to disclose loan cost information, such as:
- Annual percentage rate (APR)
- Standard and penalty fees
- Payment schedule
- Total loan amount
- Number of payments
This act was passed in an effort to provide consumers with the information they need to make smart financial decisions and comparison shop for loans. Moreover, the Credit Card Accountability Responsibility and Disclosure Act of 2009 was an addition to TILA. Also known as the Credit CARD Act, it protects borrowers and curbs predatory lending practices.
Final notes: Using finance charges in your business
Before you consider charging any interest or finance fees, you need to establish a line of communication with your customers. In the first month of working with your customer—or during a transition—make sure you take the time to explain your company’s payment processes and credit policies and put it all in writing.
Create a detailed billing agreement that states the terms and conditions of your agreement to clearly communicate your expectations. For example, if you’re issuing late fees, indicate the grace period and the amount of interest that’ll be charged. Doing so will prevent confusion between you and your client down the line.
Then, explain how much you value your partnership, be clear about your needs, and ask about what has caused delays in the past, all with the goal of avoiding finance charges if possible. These preventative measures will create a foundation of constructive dialogue between you and your customer. Ensure you make it clear to your customers what steps they can take to avoid getting billed with finance charges.
When it’s time to bill interest or other service fees, you’ll need a robust accounting software to assist you with your invoices. QuickBooks can help you free up your time by helping you track clients with outstanding balances, evaluate their finance charges, and automatically bill their invoices.
While finance charges may seem intimidating at first, having a policy that includes late fees and incentivizes early payments can encourage clients to pay on time and help you stay in control of your cash flow.
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