Private lenders are in the business to build wealth. Nonetheless, the higher interest rates associated with private money lending mean lenders must be aware of the state’s usury laws in which they’re lending.
What is Usury?
Usury laws protect borrowers from predatory lending by setting standards for interest rates and fees. Under California’s usury law, lenders are required by law to limit simple interest on loans to 10% per year, with exemptions that you could drive a truck through. Nonexempt lenders who fail to comply may face stiff penalties, including repayment of all interest paid, punitive damages, and even criminal prosecution and jail time.
While it sounds simple enough – be licensed or don’t charge over 10% interest – the complexity of usury law can be difficult to navigate, especially when compounding interest and fees enter the picture. On top of that, the burden is always on the lender. That means even if a borrower proposes the usurious interest rate, the lender is still on the hook.
How to Avoid Usury Liability
Below are 8 tips to help lenders avoid usury liability:
1. Give written notice to your borrower when applicable
To correct excess payments
Lenders can avoid usury penalties by acting promptly when they learn of a violation. If the lender discovers the excess payments, they must take action to correct it. If a borrower gives the lender written notice of usury, the lender must correct the violation and give written notice to avoid liability.
To correct excess interest
The same goes for erroneously charging excess interest. If lenders realize they’ve charged too much, the best course of action is to follow up immediately with a correction letter.
2. Build usury savings clauses in your loan agreements
Lenders should also be sure to build usury savings clauses in loan agreements. These clauses seek to reclassify interest payments as principal if interest rates exceed state standards, or they allow excess payments to be refunded to the borrower. Lenders should beware that savings clauses can prevent legal action but are not always held up in court when usury claims arise.
3. Be aware of your lending state’s regulations
Many states have a lower interest rate threshold if no written lending agreement exists. However, invoices with interest stipulations can count as a written contract, allowing lenders to charge higher interest rates associated with contract-based lending. If a borrower has paid invoices and late fees, this is considered an agreement to pay interest.
4. Allow the borrower to calculate their principal and interest
Lenders can face charges for both charging and receiving usurious interest. They can avoid some usury liability by allowing borrowers to calculate their own principal and interest payments due. This relieves lenders from claims of charging usurious interest. Lenders can still be liable for receiving usurious interest if the borrower miscalculates their payment and overpays. However, this can be remedied simply by refunding the excess payments.
5. Know what specific charges are considered “interest”
Qualified commercial loans
Qualified commercial loan contracts can include certain charges that are not considered interest. This includes commissions for securities underwriters, options to convert loan principal into equity, options to purchase equity of the obligor and a profit participation interest.
Secondary mortgage loans
Secondary mortgage loans, like home improvement loans, can include specific charges in the loan agreement that are not considered interest. These include enforcement fees, attorney’s fees for collection, court costs for collection, fees for dishonored checks, and a handful of closing fees, including loan document preparation fees, appraisal fees and premiums for property insurance.
6. Settlement of prior debt should be entered separately
This is to ensure payments under the settlement cannot be misconstrued as additional interest.
7. Beware of settlement claims
Lenders who choose to settle usury claims should do so in good faith and be prepared for additional scrutiny as settlements have been used to obscure continued or additional usury.
8. Keep track of verbal vs. written discussion
If the lender and borrower have a non-usurious agreement in writing, verbal discussion cannot be used against the lender in usury claims.