Can you charge a higher interest rate after a promissory note defaults?

Yes, in most cases, if the note says so before the default happens. A default interest rate clause lets the lender charge a higher rate once the borrower misses a payment or breaks another term. The higher rate generally still has to fit under the state usury cap, and it must be a reasonable estimate of the lender's added cost and risk.

How does a default interest rate clause work?

The clause sets a second rate that replaces the regular rate when a default occurs. A well-written clause answers four questions. What counts as a default? What is the new rate? When does it start and stop? And which balance does it apply to?

Here is a simple example. Suppose the unpaid balance is $20,000, the regular rate is 8%, and the default rate is 12%. At 8%, a year of interest on $20,000 is $1,600. At 12%, it is $2,400. The default rate costs the borrower an extra $800 a year, or about $66.67 a month, until the default is cured or the balance is paid.

If you never wrote a default rate into the note, you generally cannot add one after the borrower falls behind. The borrower agreed to the terms on the page, and a lender cannot change them alone.

Does the default rate have to stay under the usury limit?

You should plan as if it does. Most states cap the interest a private lender can charge, and courts do not all agree on whether a rate that applies only after default counts toward that cap. The safest course is to keep the default rate at or below the limit.

The stakes can be high. In New York, General Obligations Law 5-501 and Banking Law 14-a set a civil cap of 16% a year for most loans under $250,000, and General Obligations Law 5-511 makes a usurious note void. In North Carolina, a loan of $25,000 or less is capped at the rate set under G.S. 24-1.1(c), which is never below 16%, while larger loans may carry any rate the parties agree to in writing.

Run the numbers on a real case. Suppose a New York note for $50,000 carries a regular rate of 14% and a default rate of 18%. The regular rate is under the 16% cap, but the default rate is two points over it. If a court counts the default rate as interest, the lender has a usury problem on a note that would otherwise have been fine. Setting the default rate at 16% removes the risk.

Before you choose a number, check your state with our usury limit checker.

When is a default rate an unenforceable penalty?

Courts generally enforce an extra charge that is a fair advance estimate of the harm a breach will cause. They often refuse to enforce a charge whose main purpose is to punish the borrower or scare the borrower into paying. A default rate sits right on that line.

A few things make a default rate easier to defend. The increase is modest compared with the regular rate. It applies to the unpaid balance only, from the date of default until the default is cured. It does not stack on top of a large late fee for the same missed payment. A rate that doubles or triples the contract rate, or that reaches back to the date of the loan, invites a challenge.

Can you combine a default rate with late fees?

Many notes do, but stacking draws attention. For consumer credit, the Federal Trade Commission (FTC) Credit Practices Rule at 16 CFR 444.4 makes it unfair for a creditor to collect a late charge on a payment that is otherwise full and on time when the only delinquency comes from late fees charged on earlier installments.

That rule covers creditors extending consumer credit. A private loan between individuals may fall outside it, but the same idea is a good guide for any note. If your note has both a late fee and a default rate, say plainly which one applies to what. A late fee can cover the cost of chasing a single late payment, while the default rate covers the period the loan stays in default.

What interest applies after the lender wins a judgment?

Once a court enters judgment, a statutory rate often replaces the contract rate unless the note says the contract rate continues. Two state rules show how this works.

In North Carolina, G.S. 24-5(a) says that if the parties agreed in the contract that the contract rate applies after judgment, interest runs at that rate after judgment. Otherwise, it runs at the legal rate, which G.S. 24-1 sets at eight percent. For credit extended for personal, family, household, or agricultural purposes, the judgment carries the lower of the legal rate or the contract rate.

In New York, CPLR 5004 sets interest at nine percent a year, except where another statute provides otherwise. For a consumer debt where a natural person is the defendant, the rate is two percent a year.

How should you word a default interest clause?

Keep it specific. A clause along these lines covers the key points: "After an Event of Default, the unpaid principal balance will bear interest at 12% per year from the date of default until the default is cured or the balance is paid in full, but never above the highest rate allowed by law. This rate applies before and after any judgment to the extent the law allows."

Define each event of default elsewhere in the note, such as a payment more than 15 days late or the borrower's bankruptcy. Consider a short grace period and a written notice before the default rate begins. A borrower who gets a clear warning has a fair chance to catch up, and a court is more likely to see the higher rate as reasonable when the borrower ignored that chance. Include a savings clause that lowers any rate to the legal maximum. Pick a default rate a court would see as a fair measure of your added risk. Finally, if your note allows acceleration, say whether the default rate applies to the full accelerated balance.

Sources

• N.Y. General Obligations Law 5-501
• N.Y. General Obligations Law 5-511
• N.Y. CPLR 5004
• N.C. G.S. 24-1.1
• N.C. G.S. 24-5
• N.C. G.S. 24-1
• 16 CFR Part 444, Credit Practices