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What is the legality of charging default interest on hard money loans?

Over the years many clients have asked me about the legality of default interest on hard money loans. We are talking about an increase in the interest rate on a private money mortgage due to monetary and non-monetary defaults by a borrower. The rationale for the higher rate is the extra administrative work the lender and its loan servicer must do. They must contact the borrower to determine the cause of the default, determine the possible duration of the default and perform an analysis of the options open to the lender. Those options include a modification, forbearance, foreclosure or simply nothing. Assuming the loan servicer doesn’t take most of the default interest via its loan servicing agreement, default interest on a well secured hard money loan can mean a higher yield to the patient investor.

Default interest is a form of liquidated damages. That means it is a stipulated method of setting the lender’s damages due to the borrower’s default. To a borrower forced to pay it, however, it feels like a punishment or penalty because (in the borrower’s mind) the lender is over-secured and very unlikely to suffer any real harm.

Default interest on consumer mortgages is only specifically banned for high cost (Section 32) mortgages. That opens the door for default interest rate on prime and higher-priced (Section 35) consumer home loans. 1026.32(d)(4). More on that later.

The law on default interest in California is in transition. To understand what I mean, you have to trace the history of the topic through a statute and the cases that have interpreted it.

The California statute that regulates liquidated damages is Civil Code Section 1671. Prior to 1977 Section 1670 and 1671 provided:

  1. Every contract by which the amount of damage to be paid, or other compensation to be made, for a breach of an obligation, is determined in anticipation thereof, is to that extent void, except as expressly provided in the next section.
  2. The parties to a contract may agree therein upon an amount which shall be presumed to be the amount of damage sustained by a breach thereof, when, from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage.

Construing the old statutes in 1973, the California Supreme Court (with Rose Bird as the Chief Justice) in Garrett v. Coast & Southern Sav. & Loan held that default interest provisions were void:

We are compelled to conclude that a charge for the late payment of a loan installment which is measured against the unpaid balance of the loan must be deemed to be punitive in character. It is an attempt to coerce timely payment by a forfeiture which is not reasonably calculated to merely compensate the injured lender. We conclude, accordingly, that because the parties failed to make a reasonable endeavor to estimate a fair compensation for a loss which would be sustained on the default of an installment payment, the provision for late charges is void. We are compelled to conclude that a charge for the late payment of a loan installment which is measured against the unpaid balance of the loan must be deemed to be punitive in character. It is an attempt to coerce timely payment by a forfeiture which is not reasonably calculated to merely compensate the injured lender. We conclude, accordingly, that because the parties failed to make a reasonable endeavor to estimate a fair compensation for a loss which would be sustained on the default of an installment payment, the provision for late charges is void.

Section 1670 was repealed in 1977 and Section 1671 was amended to place the burden on the party challenging a liquidated damages provision to prove that it was an unreasonable estimate of damages at the time the contract was made—a nearly impossible feat. Two subsequent cases, one published and one unpublished, have confirmed that the tables have been turned and that default interest is very likely to be upheld if challenged

In Weber, Lipshie & Co. v. Christian (1997) 52 Cal.App.4th 645 (a published decision) an accountant signed a partnership agreement agreeing he wouldn’t represent the firm’s clients if he left. If he did he would owe liquidated damages equal to one years’ billings. The court distinguished Garrett, holding instead: “Subdivision (b) of Civil Code section 1671 states a presumption of validity of a liquidated damages clause, and places the burden on the party who seeks invalidation to show that ‘the provision was unreasonable under the circumstances existing at the time the contract was made.’” It upheld the liquidated damages provision.

In Goldenpark, LLC v. Urban Commons, LLC (2015) (unpublished, therefore cannot be cited), the court was faced with a defaulted loan contract with a 5% default interest rate increase. The borrower cited Garrett to no avail. The court held Garrett was overruled by the amendments to Section 1671, citing Weber, Lipshie & Co. v. Christian.

It is my belief that the Weber and Goldenpark represent the most likely result if a borrower attempted to challenge a default interest rate provision in a hard money business purpose loan. Another potential grounds for challenge is unconscionability, which is why I do not recommend default interest provisions in consumer mortgages.

If you are going to use a default interest provision in your private money business purpose loans, look at the clause carefully and ask yourself:

  1. Does my clause require notice to the borrower before I start the default rate clock ticking? You want your contract to say that default interest can be imposed without notice. As a courtesy (and inducement) you should let your borrower know you are charging it.
  1. Does my clause require acceleration of the unpaid balance before default interest starts? You want your clause to say default interest starts from the date of breach and does not require acceleration of the unpaid balance.
  1. If your investor requires you to manage defaults, does your servicing agreement give you a portion of the default interest? If you are doing the work, you deserve to be paid.

Lastly, we recommend you hold off on default interest on a payment default until the 30 day mark. After all, you are getting a late charge for the first half of that period. Charging default interest on top of a late charge is likely to anger a borrower. Remember, angry borrowers often seek legal help to even the score. That will end up costing you more than you made.

This article is intended as educational material not legal advice. Consult a knowledgeable lawyer before implementing any of the ideas in this publication.