Default Interest Rate: The Shock Factor

By: Jaspreet Kaur, Esq.

To encourage borrowers to make timely payments on their loans, lenders often include both late fee and default interest provisions in their promissory notes. It is important to understand that these provisions are designed to serve different functions, and California courts analyze them differently.

Conceptual Differences between a Late Charge and Default Interest

A late fee is usually expressed as either a flat fee or a percentage of the missed or late payment, and is meant to compensate the lender for its internal costs in administering the late payment. A default interest provision, on the other hand, raises the interest rate for the remainder of the loan period until the default is cured. It is meant to compensate the lender for the increased risk of dealing with an unreliable borrower that has defaulted, and to compensate the lender for lost opportunity costs in reinvesting loan proceeds.

Is a Default Interest Rate Provision Permissible?

For business purpose loans, charging default interest is the norm, not the exception, in California.[1] When determining whether a default interest rate is permissible, courts examine these provisions on a case-by-case basis. Unfortunately, there is no magic number that is considered the ceiling under California law. The good news is that the courts generally defer to what the parties contracted to in the promissory note.

When evaluating the permissibility of a late charge, courts analyze whether the late charge bears a reasonable relationship to the probable loss of the lender resulting from the late payment.[2] The scrutiny of a default interest rate is not as strict. Courts will typically give deference to freedom of contract and only look to whether the default interest rate rose to such a level of being “unconscionable.” Unconscionability is usually viewed in terms of whether the contract provision is so excessive that it “shocks the conscience.” For example, the California Court of Appeals held that a default interest rate of 200% for a loan term of 18 months “shocked the conscience,” and reduced it to 24%.[3]

Even though courts defer to what the lender and borrower agreed to with regard to a default interest provision, courts will look to how the lender administers the default interest rate provision to determine if it is in accordance with the promissory note. In one case, the promissory note stated that the interest rate would increase by 2% from “the date the unpaid interest started to accrue until the close of business day upon which the payment curing the default is received.”[4] The lender, rather than following the terms of the promissory note, was actually charging a 2% fee on the entire unpaid principal balance no matter if the payment was one day late or nineteen days late. The court held that the 2% fee, which was disguised as default interest, was actually an impermissible penalty that was punitive in character.

Other Considerations

Lenders must also be mindful of the different scenarios in which a default interest rate can be charged, as they are interpreted differently by the courts. There are two broad scenarios: (1) when the borrower misses one or two monthly payments, and (2) when the borrower misses the payment due upon maturity of the loan.

When a borrower misses a monthly payment, courts will review the promissory note to see if there is in fact a default interest provision the parties agreed to, and will generally give deference to the contracted terms. However, if a lender attempts to retroactively charge an increased interest rate upon the entire term of the loan when the borrower misses, or is late on, a single payment, it will likely be considered unconscionable and will be struck down.[5]

A trickier scenario is when lenders wish to charge default interest when the borrower misses the final maturity payment. As stated above, the increase must not be unconscionable, but the promissory note must also explicitly state that there will be an increase in the interest rate upon maturity. Courts have held that stating that there is a fee for a late “installment” does not apply to a payment upon maturity, because as a matter of contractual interpretation, a payment due upon maturity is not an “installment.”[6]

Conclusion

There is no hard and fast default interest rate that lenders are permitted to charge under California law. Courts give deference to the freedom of contract when it comes to default interest rate provisions, which typically are upheld so long as the provision does not “shock the conscience.”

Additional questions or comments? Contact attorney Jaspreet Kaur at Jaspreet.Kaur@geracilawfirm.com. Geraci Law Firm is a law firm dedicated to the representation of lenders, brokers and other real estate professionals. The firm has thirteen attorneys with experts in securities, lending compliance, document preparation, litigation and secured creditors rights.

[1] It is worth noting that there may be statutory restrictions or prohibitions for default interest. For example, a consumer purpose high cost loan covered by Section 32 of the Truth in Lending Act prohibits lenders from charging default interest on a covered loan.

[2] Cal. Civ. Code § 1671.

[3] Carboni v. Arrospide, 2 Cal. App. 4th 76, 80 (1991) (distinguishing between a short-term 90 day loan with a low principal balance with a permissible 200% default interest rate, and an 18-month loan with a higher principal balance).

[4] Garrett v. Coast & S. Fed. Sav. & Loan Ass’n, 9 Cal. 3d 731, 735 (1973).

[5] Id. at 735 n.3, 740.

[6] See, e.g., JCC Development Corp. v. Levy, 208 Cal. App. 4th 1522, 1524 (Cal. App. 2d Dist. 2012); In re Crystal Props., 268 F.3d 743, 745 (9th Cir. 2001).