Defaulted interest: Overview, definition, and example
What is defaulted interest?
Defaulted interest refers to the interest that accrues on an outstanding debt or loan when the borrower fails to make the required payments according to the terms of the agreement. When a borrower defaults on a loan, meaning they fail to pay the principal or interest on time, the lender may apply defaulted interest. This is typically a higher interest rate or penalty fee that is charged on the overdue amount to compensate the lender for the delay and the increased risk of non-payment.
Defaulted interest is often included in loan agreements, credit contracts, or mortgages to discourage late payments and compensate the lender for the inconvenience, administrative costs, and potential financial risk associated with the borrower’s failure to meet the payment terms.
Why is defaulted interest important?
Defaulted interest is important because it provides a financial incentive for borrowers to make timely payments and discourages defaulting on loans or credit obligations. It also helps protect the lender’s financial interests by compensating for the potential loss of income, administrative costs, or legal fees incurred due to the default.
For businesses or individuals lending money, defaulted interest is a way to mitigate the risks of late payments, particularly if there is a concern about the borrower’s ability to repay. For borrowers, understanding the impact of defaulted interest emphasizes the importance of making payments on time to avoid additional charges and financial strain.
Understanding defaulted interest through an example
Imagine a company takes out a loan of $100,000 with a repayment schedule that requires monthly interest payments of $1,000. If the company misses a payment and the loan goes into default, the lender may impose a higher defaulted interest rate of 10% annually instead of the original 5%. This increased rate would apply to the outstanding balance, so if the loan remains unpaid for an additional month, the interest owed would be calculated based on the new, higher rate, leading to significantly higher costs for the borrower.
In another example, an individual has a mortgage with a 4% annual interest rate and is required to make monthly payments. If the individual misses a payment and the loan enters default, the lender might charge defaulted interest of 6% annually on the overdue balance until the missed payment is made. This results in an increased amount owed due to the default.
An example of a defaulted interest clause
Here’s how a defaulted interest clause might look in a loan agreement:
“In the event of a default, the Borrower shall be liable to pay interest on the outstanding amount at a rate of [Insert Default Interest Rate] per annum, which is [Insert Percentage] higher than the original agreed-upon interest rate, commencing from the date of default until the loan is paid in full.”
Conclusion
Defaulted interest serves as a penalty for borrowers who fail to meet their payment obligations, providing compensation for lenders due to the risks and administrative burdens associated with late payments. By including a defaulted interest clause in contracts, both parties are aware of the consequences of non-payment, which helps incentivize timely repayments and reduces the risk of financial loss for the lender. For borrowers, understanding the cost of defaulted interest reinforces the importance of adhering to agreed-upon payment schedules.
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.