Default interest: Overview, definition, and example
What is default interest?
Default interest is the additional interest charged by a lender or creditor when a borrower fails to make timely payments according to the terms of a contract or loan agreement. This interest is intended to compensate the lender for the risk and inconvenience caused by the borrower’s failure to meet the agreed-upon payment schedule. Default interest typically applies to the overdue amount and is often higher than the regular interest rate to encourage timely repayment.
For example, if a borrower misses a payment on a loan, the lender may charge default interest on the overdue amount until the payment is made.
Why is default interest important?
Default interest is important because it provides an incentive for borrowers to adhere to the terms of a loan or contract, reducing the risk of late payments. It also compensates the lender for the added costs and risks associated with delayed payments. Default interest ensures that the lender is not unfairly harmed when a borrower fails to fulfill their payment obligations and encourages prompt resolution of overdue balances.
For businesses, including default interest clauses in contracts or loan agreements can help mitigate financial risks and maintain cash flow by ensuring that overdue payments are addressed in a timely manner.
Understanding default interest through an example
Imagine a business that has taken out a loan with an interest rate of 5% per year. If the business misses a scheduled payment, the loan agreement specifies that a default interest rate of 10% per year will be applied to the overdue amount. This higher interest rate serves as a penalty for the late payment and provides additional compensation to the lender.
In another example, a supplier provides goods to a retailer and agrees on payment terms of 30 days. If the retailer fails to make the payment within this period, the supplier may charge default interest at a rate of 2% per month on the overdue amount, as outlined in the terms of the agreement.
An example of a default interest clause
Here’s how a default interest clause might look in a contract:
“In the event of a late payment, the Borrower agrees to pay default interest at a rate of [Insert Percentage]% per annum on the overdue amount, in addition to the regular interest rate. Default interest will be charged from the date the payment is due until it is fully paid.”
Conclusion
Default interest serves as a tool to incentivize timely payments and compensate lenders for the risks associated with delayed payments. By including a default interest clause in contracts, businesses can help ensure that their payment terms are respected, reduce the financial impact of late payments, and encourage borrowers or clients to settle their debts on time.
Clear default interest provisions in agreements help maintain financial stability and minimize the impact of overdue payments on business operations.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.