Consider these protocols for when to charge default interest and how to develop a default interest policy.

Many lenders have provisions in their loan contracts to charge a higher interest rate if a borrower defaults on their loan. The default interest remains in effect until the loan is again current. When determining the rate, it’s crucial that private lenders calculate the risk and cost involved in making their small business whole. The following serve as guidelines to determine when, how, and how much default interest to charge.

As a best practice, the American Association of Private Lenders recommends a default interest rate no greater than 18%-25%, with the rate accurately representing the loan’s greater risk and actual loss to the lender.

Default Interest Mindset

When determining what default interest to charge, lenders should keep the following in mind.

Compensation for Financial Loss. Default interest compensates lenders for the financial loss they experience when borrowers fail to fulfill their obligations. Private lenders are nearly universally small businesses. They are not banks with depository accounts, and their primary source of business income is loan repayment. Defaults can have a significant impact on their ability to maintain operations, meet expenses, or grow their enterprise. Default interest helps to mitigate this financial loss and ensure lenders can recover their investments.

Risk of Non-Consumer Borrowers. Non-consumer borrowers typically pose higher risks. They often rely on loans to support their operations and growth, and their financial stability is closely tied to market conditions and economic factors. Recognizing and accounting for this higher risk is essential in setting an appropriate default interest rate.

Recovery of Costs. Defaulting borrowers may trigger additional costs for lenders (e.g., legal fees, collections, and administrative expenses associated with resolving the default). Lenders can recover a portion of these expenses by incorporating them into the default interest rate. It is important to strike a balance that is fair to both parties. The rate should be reasonable, considering the borrower’s circumstances, prevailing market conditions, and the actual costs incurred by the lender.

Preservation of Creditworthiness. Defaulting on a loan can tarnish a borrower’s creditworthiness, making it more challenging for them to secure future financing or negotiate favorable terms. The imposition of default interest emphasizes the importance of honoring loan obligations and encourages borrowers to take their repayment responsibilities seriously, thereby safeguarding their creditworthiness.

Encouraging Responsible Borrowing Behavior. Default interest acts as a deterrent against delinquency and encourages responsible borrowing behavior from non-consumer borrowers. It incentivizes timely payments and adherence to loan terms, promoting a sense of accountability and fostering a healthier lending relationship between borrowers and lenders.

Best Practices for Charging Default Interest

When you, as a lender, find yourself in a situation where you must charge default interest or implement default interest on a first mortgage lien, it is important to follow best practices to ensure fairness and clarity. Here’s a guide on how to handle such a scenario:

Clearly Define Default. Start by clearly defining what constitutes a default in your loan agreement. Specify the specific events or conditions that would trigger the imposition of default interest. This could include missed payments, failure to maintain insurance, or breaching other terms of the loan.

Establish Default Interest Rate. Determine the default interest rate that will apply when the borrower defaults. This rate should be clearly stated in the loan agreement and conform to any applicable laws or regulations. It’s advisable to consult with legal professionals to ensure compliance with local regulations.

Provide Notice. When a borrower defaults, promptly provide written notice to the borrower specifying the default and the imposition of default interest. Include details such as the amount owed, the new interest rate, and the timeframe within which the borrower must rectify the default to avoid further consequences.

Document Communications. Keep thorough records of all communication with the borrower regarding the default and the implementation of default interest. This includes sending notices via certified mail or any other traceable method to ensure you have evidence of providing timely and accurate information. This is why lenders often opt to have a licensed and reputable third-party servicing company handle their portfolio. Using a vetted third party helps remove the daunting task of sending all proper correspondence and mitigates some of the necessary human capital it would take to stay current and compliant with state and federal regulation.

Transparency and Clarity. Maintain transparency and clarity throughout the process. Clearly explain to the borrower why default interest is being charged and how it is calculated. Provide an itemized breakdown of the charges, including any applicable fees or penalties, to ensure the borrower understands the consequences of defaulting.

Compliance with Applicable Laws. Ensure that your actions align with local laws, regulations, and any governing bodies that oversee lending practices. Familiarize yourself with usury laws, interest rate limits, and any specific requirements related to default interest in your jurisdiction.

Consider Alternatives. Although charging default interest may be necessary in some cases, it’s worth considering alternatives. For instance, working with the borrower to establish a modified payment plan or exploring options for loan restructuring could help avoid default interest altogether. This is why you have begun to hear and/or see some small, mid, and even larger lending institutions implement asset management or loss mitigation teams. Depending on the geography of any one lender’s portfolio, loss mitigation to achieve a reperformance or a quick return of the hard asset is a much more economical solution.

Seek Legal Advice if Necessary. If the situation becomes complex or legal disputes arise, seek legal advice from professionals experienced in lending and mortgage laws. They can provide guidance on the best course of action and ensure compliance with legal requirements. Further, lean on your third-party servicer to recommend legal resources and recent regulations pertaining to the proper course of action when pursuing lawful default.

Remember, these best practices are general guidelines, and it’s important to consult with legal professionals and adhere to specific legal and regulatory requirements in your jurisdiction. By following these best practices, you can effectively charge default interest on a first mortgage lien while maintaining transparency, fairness, and compliance with legal requirements.

Stay Up to Date

When developing your default interest policy consider these key factors:

Legal and Regulatory Compliance. To ensure you stay informed of usury laws, guidelines, and standards, there are several best practices you can follow, including the following:

• Seek legal consultation from legal professionals experienced in lending and finance laws. They can provide guidance specific to your jurisdiction and help you understand the nuances of usury laws and regulations. Regularly consult with them to stay informed about any updates or changes in the legal landscape.
• Familiarize yourself with regulatory bodies responsible for overseeing lending practices in your jurisdiction. Stay updated on their publications, guidelines, and enforcement actions related to usury laws. These organizations often provide resources and updates that can help you understand and comply with the latest standards.
• Join relevant industry associations or organizations that focus on lending and finance. These associations often provide valuable resources, training programs, and networking opportunities that can keep you informed about usury laws and best practices. Attend conferences, webinars, and seminars organized by these associations to stay up to date with the latest developments in the field.
• Invest in your professional development by attending courses, workshops, or webinars that specifically cover usury laws, lending regulations, and compliance standards. These educational opportunities can provide you with valuable insights and ensure you remain knowledgeable about changes in the industry.
• Conduct regular research on usury laws and related legal frameworks. Familiarize yourself with relevant statutes, case law, and legal commentary. Online legal databases, legal publications, and law libraries can serve as valuable resources for staying informed about the latest interpretations and applications of usury laws.

Networking and Collaboration. Engage in professional networks and forums where lending professionals gather. Participate in discussions, ask questions, and share insights related to usury laws and compliance. Collaborating with peers and industry experts can provide practical perspectives and help you stay informed about emerging trends and challenges.

Government Resources. Government agencies and departments responsible for regulating lending practices often provide resources, publications, and updates on usury laws. Visit their websites, subscribe to newsletters, and follow their social media accounts to receive timely information and notifications about changes in regulations.

Industry Standards and Best Practices. Research industry standards and best practices regarding default interest. Look into how other lenders handle default interest and consider adopting practices that are widely accepted and proven to be fair and reasonable. This helps you establish a policy that is consistent with market norms.

Risk Assessment. Evaluate the risks associated with defaulting borrowers and the potential financial impact on your institution. Consider factors such as the borrower’s creditworthiness, loan-to-value ratio, and the overall health of the real estate market. This assessment helps you determine an appropriate default interest rate that balances your risk exposure while remaining fair to the borrower.

Reasonableness and Proportionality. Strive to set default interest rates that are reasonable and proportionate to the borrower’s default. Charging excessively high rates may be seen as predatory or unfair. Consider the additional costs and risks incurred as a result of default and ensure the default interest rate reflects a genuine reflection of those factors.

Transparency and Communication. Clearly communicate your default interest policy to borrowers. Include detailed information about the default interest rate, how it is calculated, and the circumstances that trigger its imposition. Make sure the policy is written in clear and understandable language to avoid any confusion or misunderstandings.

Consistency and Non-Discrimination. Apply your default interest policy consistently and without discrimination among borrowers. Treat all borrowers equally, ensuring the policy is applied uniformly regardless of race, gender, or other protected characteristics. Consistency and fairness promote trust and minimize the risk of legal challenges.

Review and Adaptation. Regularly review your default interest policy to ensure its effectiveness and relevance. Monitor changes in the lending industry, regulatory landscape, and economic conditions to identify any necessary updates or improvements. Staying proactive and adaptable helps you maintain a policy that is responsive to evolving circumstances.

Documentation and Records. Maintain thorough documentation and records of your default interest policy, including any updates or revisions. Keep a record of borrower acknowledgments, signed agreements, and any relevant communication regarding the policy. This documentation serves as evidence of transparency and can be valuable in case of disputes or legal inquiries.

By considering these factors when developing your default interest policy, you can establish a fair, compliant, and transparent framework that protects your institution’s interests while maintaining a balanced approach toward borrowers in default. By incorporating these best practices into your routine, you can stay well-informed about usury laws, guidelines, and standards. Remember, it is crucial to consult with legal professionals for specific advice tailored to your jurisdiction and to regularly update your knowledge to ensure compliance with applicable laws and regulations.